Tax-free Bond Funds?

[HalMd]

My family is finally to the point where we can consider investing outside our retirement accounts. I'm favoring a diverse portfolio of no-load mutual funds.

My question is, does anyone have experience using a tax-free bond fund for your state? For instance T. Rowe Price Maryland Tax-Free Bond Fund (MDXBX).

These kinds of funds invest in muncipal bonds which are attractive for investors in high tax states because they are tax-free both federal and state.

They seem to do better than CDs and Money Markets for that low-risk/return portion of a portfolio. I'm thinking of, say, 20% in tax-free bond funds.

Assume I'll keep the investment for at least 5 years, and maybe 10-20. Does anyone have an arguement for or against tax-free bond funds?

[disneysteve]

I think tax-free bond funds are fine. Just be sure to run the numbers for your particular situation and be sure the tax-equivalent yield of the fund is better than other taxable investments.

Of course, keep in mind that money invested in a bond fund can potentially lose principal value, so they are a bit riskier than CDs or money market accounts where your principal is fixed.

[sweeps]

I don't invest in them, but I did read an article recently that advises to look into what the fund means by tax-free. If you're subject to the AMT (alternative minimum tax), your tax-free bond fund may be anything but.

[HalMd]

From the T. Rowe Price prospectus...

"[These funds] invest in municipal bonds issued by a single state. The income these funds distribute is generally exempt from federal and state tax for residents of that state because most states do not tax the income generated by their own bonds or their governmental entities."

[sweeps]

Some income may be subject to the federal alternative minimum tax.

Source: T Rowe Price

[scfr]

We don't have any state income tax where we live, but we recently invested in a broad-based (not state-specific) municipal bond fund. [This was also our first non-retirement investment account, BTW!] We've been happy with it so far, but have only been in it for a few months.

Regarding taxes: You won't pay tax on the dividends ("the income the fund distributes" in your T.Rowe quote), but you will pay federal tax on the gains in share price (if any) when you sell. I don't know if you will pay state tax on the gains; that would depend on your state law.

For more information, a good web site is the Bond Market Association: www.investinginbonds.com (Click Learn More on the right side, then About Municipal Bonds). They publish a book called "The Fundamentals of Municipal Bonds" which is extremely comprehensive; it's also expensive (I checked my copy out from the library).

Learn how to calculate your TEY (tax equivalent yield) .... Muni Yield / (1 - Your Marginal Tax Rate). That means that if your federal marginal tax rate is 33%, a 4% tax-free muni fund yield is the equivalent of a 5.97% yield if you paid federal taxes on it. It's even better when you factor in the state tax savings.

If you want to reduce your risk, look at the average credit rating of the bonds your fund invests in and look at how many of the bonds are insured.

With a fund like a muni fund, where you're not really looking for a hotshot manager who can outperform the market, costs are of utmost importance. IF you happen to have $100K to invest, you may want to look at Vanguard Admiral Shares which have impressively low costs. The only state funds currently available from Vanguard with Admiral Shares are CA, FL, NJ, NY, PA; sorry, no Maryland.