How to Avoid Paying Taxes on Tax-Free Funds

Fearing tax hikes from President Clinton and many cash-strapped states, investors poured billions of dollars into tax-free municipal bond mutual funds last year.

However, at this time of year, many new investors find themselves grappling with mutual fund tax questions. And the issues involved in investing in tax-free funds are not quite as clear as they might seem. In some cases, for example, income earned on tax-free funds is taxable.

Here are some answers to common taxation questions about tax-free funds:

Q: What is a tax-free fund?

A: Usually, it is a fund that invests in bonds and other tax-exempt obligations of federal and state governments. Frequently, they are municipal bond funds, which invest in the debt securities of one or several states.

Interest earnings on these debt securities are usually passed through as tax-free dividends to investors. That allows high-income taxpayers to earn a reasonably high after-tax rate of return with very little risk.

Q: Some of these funds advertise returns of 4% to 6%. Why is that so good?

A: If it was a before-tax return, it wouldn’t be. But because investors often don’t have to pay federal or state tax on the earnings, their real return is higher. Earning 5% on a fully tax-free fund is the equivalent of earning 7% on a taxable fund for somebody who pays 40% of their income in state and federal taxes.

Q: When could earnings from a tax-free fund be taxable?

A: There are several ways you might incur tax liability on income from a tax-free fund.

First, you may sell your fund shares at a profit, in which case you would have to declare a capital gain.

Secondly, the fund may sell bonds in its portfolio at a profit, in which case it would declare a capital gain and pass that taxable gain on to you.

Finally, funds that invest in direct obligations of the U.S. Treasury are usually exempt from state taxes, but not federal tax. On the other hand, some municipal bond funds are subject to state tax.

Q: Why would a municipal bond fund be subject to state tax?

A: Some municipal bond funds invest in the bonds of many states. As a result, individual states sometimes impose income taxes on the interest earnings of those funds.

For example, Californians who invest in funds that hold less than 50% of their assets in California municipal bonds must pay California tax on 100% of their dividend income.

Other states allow you to exclude some dividend income on multi-state funds, but not all.

Q: Why would you invest in such funds?

A: Because what they lose in tax breaks they often make up for in diversification. Diversification can limit your risks. And, of course, these funds are still exempt from federal tax.

Q: How would I know if I’m subject to state tax on a multi-state fund?

A: Finding out is usually as simple as calling your mutual fund company. By and large, warnings that the fund could incur state tax liability are in fund prospectuses that you get before you invest. Fund customer service representatives can give you additional information both before and after you invest. If your fund company can’t help, you may want to consult a tax adviser.

Q: What funds are exempt from state tax but not federal tax?

A: Funds that invest primarily in direct obligations of the U.S. Treasury, such as Treasury bills, notes and bonds.

Q: Does that also include Ginnie Mae funds?

A: No. Ginnie Maes, which are government-backed mortgage securities, are not direct obligations of the U.S. government. Earnings from these funds are usually taxed by both state and federal governments.

The Boom in Muni Funds

Investors, fearful of both federal and state tax hikes, poured $34 billion into municipal bond mutual funds in 1992. Net sales, in billions: 1988: $8.10 1989: $14.42 1990: $14.62 1991: $24.50 1992: $34.00