Taxes and Mutual Funds

Tax-managed funds
Some funds are managed to keep taxable gains and income low.
Among the strategies these funds employ are indexing (to hold down
turnover), carefully selecting which shares to sell (so that capital
losses offset most capital gains), and encouraging long-term
investing (for example, by assessing fees on shareholders who
redeem their shares soon after buying them).
Investing for tax-exempt income
Interest on most municipal bonds is exempt from federal income
tax and, in some cases, from state and local income taxes as well.
However, municipal bond funds (which pay lower yields than
taxable bond funds as the trade-off for their tax advantage) are not
for everyone. Generally, investors in lower tax brackets do not
benefit from owning municipal bond funds. The box below explains
how to compare yields on tax-exempt and taxable bond funds.
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Choose your bonds—taxable or tax-exempt?
Deciding between taxable and tax-exempt bond funds for your portfolio takes
some analysis. Municipal bonds offer the advantage of producing income
that is exempt from taxes—but they also pay yields lower than those
available on taxable bond funds of comparable quality and maturity. To
decide whether to invest in a tax-exempt bond fund or a taxable one, you
need to know which provides the best overall return.
Here is how to compare the yield of a municipal bond fund with that of a
taxable bond fund that holds bonds of similar credit quality and maturities.
First subtract the percentage of your marginal tax bracket from 1, then
divide the resulting number into the yield of the tax-exempt fund to find the
equivalent taxable yield. For an investor in the 28% tax bracket considering a
tax-exempt fund with a 6% yield, the calculation is as follows:
Example: 1.0 – 0.28 = 0.72 6% ÷ 0.72 = 8.33%
In this example, a taxable fund must provide a yield of more than 8.33% to
top a yield of 6% from a tax-exempt fund.