Tax-exempt mutual funds refer to mutual funds investing in government or municipal bonds. The interest that is generated by the bond is exempted from income tax, and that is why the fund is called tax-exempt.
In some situations, the interest of the bond that is issued in the state where you live can be exempt from federal, state, and local income taxes. Such bonds will be regarded as triple-tax-free.
You have to notice that not all mutual bonds can be free from all taxes. Treasury bonds, for instance, can only be free from local or state income tax, and they are still subject to the income tax on the federal level.
Since tax-exempt mutual funds consist of bonds issued by the government, the funds are deemed as completely risk-free. This also means the rates of return are much lower than more volatile funds or securities.
Once you have decided to invest in tax-exempt mutual funds, you can start to find and choose a suitable fund.
To find a suitable tax-exempt fund, you have to know more about the types of mutual funds so that you may pick the one that best suits your interest. Mutual bonds generally have four types: stock, bond, balanced, and money market mutual funds.
Stock funds usually consist of investments in the equity market, and bond funds are comprised of investments in debt markets. Bond funds are more stable and they can yield slow but steady income. Stock funds, on the other hand, can be more flexible but they also contain more risk.
Balanced funds have a lower risk than stock funds but the risk is higher than bond funds. Money market funds are generally comprised of investments in short-term debt securities that usually mature in 13 months.
There is one thing you have to notice. Since investors cannot control the time when bonds are purchased and sold, an unexpected tax bill may appear once the fund yields a profit from capital gains rather than interest.