Tax-exempt mutual funds are available and offer earnings that are exempt from federal income tax. Some states also exempt the earnings from state income tax, which increases their profitability. However, the lower rate of return means this investment strategy is not for all investors, warns Vanguard.
If an investment is already a part of a tax advantage account, such as an individual retirement account, the tax-free mutual fund is usually not beneficial. Most investors accept the lower rate of return to reduce their tax burden, but when investing for an IRA, the tax reduction is already in place. Investors benefit from choosing a fund with a higher return rate, advises Vanguard.
The investor should also consider his income tax bracket when deciding to invest in tax-exempt funds, according to Vanguard. For investors in higher tax brackets, the tax break from this type of investment helps to improve the overall return. For those in lower tax brackets, the tax reduction does not offset the lower earnings.
In order to determine if a tax-exempt mutual fund is a smart investment, the investor should consider its taxable equivalent yield, recommends Vanguard. This yield is what the tax-exempt investment needs to earn to meet that of a comparable taxable fund.