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Tax-exempt funds

Investors who hold a portion of their bond or money market allocation in a taxable account may want to consider tax-exempt municipal money market and bond funds.

Interest, or income dividends, paid on bonds issued by a state or local political subdivision (that is, municipal bonds) is generally exempt from federal income tax. The interest may also be exempt from state and local income taxes, provided the bonds were issued in the state in which you reside for tax purposes.

Because the income dividends from municipal money market and bond funds generally aren't federally taxable, these funds typically have lower yields than taxable money market and bond funds. Even so, if you're in one of the upper marginal tax brackets—and especially if you live in a state or locality that has high income tax rates—municipal money market and bond funds are likely to provide you with higher after-tax income than would taxable funds with similar characteristics. (Even tax-exempt funds, however, can distribute short- and long-term capital gains, which would be subject to tax.)

Although the income from a municipal bond fund is exempt from federal tax, you will pay tax on capital gains realized from a fund's trading or from the redemption of shares. For some investors, a portion of the fund's income may be subject to the alternative minimum tax. Income may also be taxed by state and local governments.

The table below provides general guidelines for helping you decide whether municipal bonds are right for you. The analysis is not based on a comparison of yields at any particular time, but rather on the historical relationship between yields available on taxable bonds and municipal bonds. As such, it sets forth helpful rules of thumb (but does not substitute for comparing actual yields on actual funds).

How much in munis?

Allocating Municipal Bond Investments
If you're in this tax bracket … You may want to allocate this portion of your bond investments in municipal bonds …
10%, 15% 0%
25% 100% of your long-term bonds (Your short- and intermediate-term holdings should be taxable bonds.)
28%, 33%, 35% 100%

As you can see, investors in lower tax brackets may be better off in taxable bonds, while higher-bracket investors may be better off in munis. For those in between, municipal bonds may make the most sense for the long-term bond portion of a portfolio. (The difference in yields between taxable and tax-exempt securities is typically wider for longer-term securities than it is for shorter maturities.)

Taxable-equivalent yield

Taxable-equivalent yield is the before-tax yield you'd have to get from a higher-paying, taxable investment to match the yield from a lower-paying, tax-exempt investment. Use our calculator to determine your taxable-equivalent yield.

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