The Price of Avoiding Taxes

I want to buy a bond fund. Should I consider a tax-exempt bond fund or a taxable fund?

Question: Where can I find information explaining how to select a bond fund and whether I should consider a tax-exempt bond fund over a taxable bond fund?

Answer: Bonds and the bond market can be confoundingly complex. That's why the average investor looking for some exposure to fixed-income securities (a fancy name for bonds) might do better buying a bond fund than trying to select individual bonds. The next decision is what type of bond fund to choose. As it turns out, though, you don't have to think very hard about whether tax-exempt, or municipal, bond funds should be part of the mix. That choice is all but made for you, since it comes down to your tax bracket. Generally, only high-income investors will find this type of fund worth their while.

Tax-exempt bond funds invest in bonds that are issued by states or local municipalities — California, say, or New York City. These muni bonds are issued to help pay for everything from bridges to dormitories at public universities. The feds are barred from taxing the interest on most state and local bonds, and many local governments will also exempt their own citizens from taxes on bonds they issue. So the income on muni-bond funds is free of federal income taxes, and can be free of federal, state andlocal taxes. There are plenty of choices of such triple-tax-free funds for residents of large, high-tax states like New York or California. If you live in a smaller state for which there is no muni-bond fund offering, you might consider a national bond fund, which can hold municipal bonds from anywhere in the country and are free of federal taxes. (Only the portion of its income that comes from the state in which you reside would be free of state or local taxes, however.)

At first glance, choosing a muni fund over a taxable bond fund would seem like a no-brainer. After all, who wants to pay taxes? Trouble is, the issuers of municipal bonds know investors will get the tax break, so they can get away with offering lower yields, or rates of interest. As of the end of November, according to Morningstar, the average national intermediate muni-bond fund has a 12-month total return of 7.57% and a yield of 4.22%, while the average taxable intermediate bond fund has a 12-month total return of 10.27% and a yield of 5.65%, according to Morningstar.

Only investors in high tax brackets would benefit from sacrificing income in exchange for a smaller tax hit, says Alan Papier, a mutual-fund analyst at Morningstar. For example, someone in the top federal bracket of 39.1% who bought a national intermediate term muni fund with a yield of 4.2% would have to find a taxable bond fund that yielded more than 6.90% to get a comparable return. But an investor in the 15% bracket would only have to find a taxable bond fund that yielded more than 4.94% to beat the tax savings of a muni-bond fund, and that's not hard to do. Generally, only investors in the 28% bracket or higher should consider municipal funds, advises Scott Kahan, a certified financial planner in New York City. Remember, though, to include state and local income-tax rates in your calculations if you live in a high-tax locality where a state-specific muni fund is an option.

Bear in mind, too, that only the income from muni funds is tax-exempt. Bond funds may also produce capital gains as the underlying bonds rise in market value, which they may do during periods of falling interest rates. And those capital gains are taxable.

Another way of avoiding taxes on your income would be to simply hold a taxable bond fund in a tax-deferred account like a 401(k) or IRA, says Papier. This strategy wouldn't make sense, however, for someone investing in bond funds for the regular income. With tax-deferred vehicles, you won't be able to touch your money before retirement without triggering a penalty.

There are other things you should look at besides the yield and the total returns of a muni fund. As with any fund, you'll want to look at the fees, which you should compare to those of other funds in the same category to make sure they're competitive. You should also check out the average credit quality of the bonds within the fund. Watch out for funds that hold bonds that are unrated by the major credit-rating agencies like Standard & Poor's or Moody's. Since such bonds often go unrated to avoid a low rating, you'll want to give them a wide berth unless you know you've got an experienced fund manager with a good track record at the helm, says Kahan.