Tax-exempt mutual funds are simply composed of investments that generate tax-free interest. They are offered by many prominent investment firms, and some even specialize in this type of vehicle.
Key Takeaways
- Mutual funds invested in government or municipal bonds are often referred to as tax-exempt funds because the interest generated by these bonds is not subject to income tax.
- While the interest on some bonds is exempt from state or local income tax, it may still be subject to federal income tax, as is the case with Treasury bonds.
- Because tax-exempt mutual funds are comprised of government-issued bonds, which are virtually risk-free, they tend to have much lower rates of return than funds that include more volatile securities.
- While the interest on government bonds is often tax-free, any capital gains realized when the bond is sold at a premium are not.
What Is a Mutual Fund?
A mutual fund is a type of highly liquid security that's highly popular among retail investors. Though a mutual fund is technically a type of investment company, the term is most often used to refer to the fund's portfolio.
Mutual funds allow many investors to pool their money, thereby leveraging their combined investing power. Investors purchase shares of the fund, which entitles them to a portion of its proceeds. The fund invests shareholder contributions into a range of securities, most commonly stocks, bonds, and short-term debt, and distributes the profits to the investors according to the size of their ownership stakes.
Types of Funds
There are four primary types of mutual funds: stock, bond, balanced and money market. As their names imply, both stock and bond funds are comprised of investments in the equity and debt markets, respectively. Bond funds, like bonds themselves, tend to be very stable and produce slow but steady income over time. Stock funds can be tailored to a variety of investment goals, from a high-risk, high-reward strategy to a diversified portfolio focused on minimizing loss potential.
Balanced funds include a combination of these two securities; usually, the bond holdings temper the stocks, to provide a medium amount of risk. Commonly called cash equivalents, money market funds are comprised of investments in short-term debt securities, such as Treasury bills (T-bills) and commercial paper, that mature within 13 months.
Tax-Exempt Funds
Mutual funds invested in government or municipal bonds, also called munis, are often referred to as tax-free or tax-exempt funds because the interest generated by these bonds is not subject to income tax. In some cases, bonds issued in your state of residence may be triple-tax-free, meaning interest is exempt from all state, local and federal income taxes.
However, not all bonds are exempt from all taxes. While the interest on some bonds is exempt from state or local income tax, it may still be subject to federal income tax, as is the case with Treasury bonds (T-bonds).
Because tax-exempt mutual funds are comprised of government-issued bonds, which are virtually risk-free, they tend to have much lower rates of return than funds that include more volatile securities. For some, the tax benefits of these assets outweigh their reduction in earning potential. Whether this trade-off is beneficial largely depends on your income tax rate and how much your investment could be earning in a taxable fund.
When considering an investment in mutual funds, it is important to know the specific tax implications of each fund, to ensure you are not blindsided by a tax bill on an investment that is advertised as tax-free.
Capital Gains
While the interest on government bonds is often tax-free, any capital gains realized when the bond is sold at a premium are not. Because investors in mutual funds have no control over when bonds are bought and sold, there is the potential for an unexpected tax bill if the fund generates a profit from capital gains rather than interest.
FAQs
Mutual funds invested in government or municipal bonds are often referred to as tax-exempt funds because the interest generated by these bonds is not subject to income tax.
How do I know if my mutual funds are tax-free? ›
Mutual funds are not tax-free except for ELSS (equity-linked savings schemes or tax-saving funds) and some retirement funds. As per the Income Tax Act, under Section 80C, you can claim a deduction of up to Rs. 1.5 lakh for investments made in ELSS and can save taxes up to Rs.
Which mutual fund is best for tax exemption? ›
List of Top Tax Saving Mutual Funds in India sorted by ET Money Ranking
- JM ELSS Tax Saver Fund. ...
- Franklin India ELSS Tax Saver Fund. ...
- Sundaram ELSS Tax Saver Fund. ...
- Invesco India ELSS Tax Saver Fund. ...
- Aditya Birla Sun Life ELSS Tax Saver Fund. ...
- Tata ELSS Tax Saver Fund. ...
- Baroda BNP Paribas ELSS Tax Saver Fund.
FMOXX - Fidelity ® Tax-Exempt Money Market Fund | Fidelity Investments.
How to invest in tax-free mutual funds? ›
How to invest
- The best way of investing into ELSS funds is through monthly SIPs (systematic investment plan). The minimum investment through a SIP can be as low as Rs 500 per month.
- At the start of every year, work out the statutory deductions and calculate what you have left over from the Rs 1.5 lakh limit.
Tax harvesting: Tax harvesting involves selling a portion of equity mutual fund units annually to realise long-term gains and reinvesting the proceeds into the same fund. This strategy helps investors keep their long-term returns below the Rs. 1 lakh threshold, thus avoiding long-term capital gains tax upon redemption.
Is it better to invest in a tax-free or a taxable mutual fund? ›
Taxable funds generally have higher returns—nominally. But if the tax on those returns effectively wipes out the additional return, the more optimal choice is the tax-free fund.
Are there any federal tax exempt investments? ›
Municipal bonds are generally free of federal tax because the interest from bonds issued by a state, municipality, or other local entity is exempt from federal taxation. As an added benefit, most states will allow a state tax exemption if the owner of the bond resides in the state of issue.
Can I withdraw from a mutual fund without tax? ›
Distributions and your taxes
If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares.
What is the best tax-exempt money market fund? ›
- Vanguard California Municipal Money Market Fund. ...
- Vanguard New York Municipal Money Market Fund. ...
- Schwab AMT Tax-Free Money Fund. ...
- DREYFUS TAX EXEMPT CASH MANAGEMENT FUND. ...
- Schwab Municipal Money Fund. ...
- Schwab New York Municipal Money Fund. ...
- Vanguard Municipal Money Market Fund. ...
- TAX-FREE MONEY MARKET FUND. BNTXX | Fund | Investor.
The tax-exempt sector comprises a wide range of investments, including bonds, leases, bond funds, mutual funds, life insurance, Coverdell Education Savings Account distributions, health savings account (HSA) distributions, and fixed annuities.
Are Treasury mutual funds tax-exempt? ›
Taxation. Interest income from Treasury securities is subject to federal income tax but exempt from state and local taxes. Income from Treasury bills is paid at maturity and, thus, tax-reportable in the year in which it is received.
Does Vanguard have a tax-exempt money market fund? ›
We offer both taxable government and municipal (tax-exempt) money market funds. Vanguard's money market funds are offered with a stable $1 NAV (net asset value).
Does Schwab have a tax-free money market fund? ›
Schwab AMT Tax-Free Money Fund's and Schwab Municipal Money Fund's dividends typically are exempt from federal income tax, but are subject to state and local personal income taxes.
What does tax-exempt mutual fund mean? ›
Although tax-exempt mutual funds usually produce lower yields, you generally don't have to pay federal taxes on earnings from tax-exempt money market and bond funds. And you can save even more if you live in a state that offers similar exemptions.
Is Vanguard tax-exempt? ›
In addition to being 100% exempt from federal income taxes, interest dividends from Vanguard state-specific municipal bond funds (listed below) may be exempt from state taxes to resident shareholders of that state, except where noted.
Is Vanguard tax-free? ›
Withdraw anytime, tax-free
Your withdrawals will be free from Income Tax and Capital Gains Tax. The Vanguard Stocks and Shares and ISA is a flexible ISA.
Which money market funds are tax-exempt? ›
Municipal money market funds invest primarily in short-term, municipal money market securities issued by states, local governments, and other municipal agencies. They pay interest that is generally exempt from federal income tax.
What investments are exempt from federal income tax? ›
The tax-exempt sector includes bonds, notes, leases, bond funds, mutual funds, trusts, and life insurance, among other investment vehicles. Government municipal bond issuers offer a guarantee, since the taxing authority typically raises funds to repay any GO bond obligations.
