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What is a Tax Exempt Fund? Tax-exempt funds, also known as municipal bonds or munis, are attractive to investors looking to reduce their tax burden. The interest earned from a municipal bond is exempt from federal tax. Most state and local governments exempt them from taxes. Tax-exempt funds are typically issued by local governments or their agencies to raise funds for developmental projects such as construction of roads and bridges.
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Why are Tax-exempt Bonds Preferred by Wealthy Investors?
Municipal bonds, because of their tax-exempt nature, are preferred by investors from all spectra but they are especially attractive to investors falling in higher tax brackets. Let us take an example to see why this is the case. Imagine that a regular bond yields $100 as interest income in an year. A person in a 10% tax bracket will be paying 10% of his adjusted gross income as tax, so his net income from the bond will be $100 minus $10, which is $90. For a person in a higher tax bracket, say 28%, the net income from the regular bond will only be $100 minus $28, which is $72. Since both individuals do not pay tax on a tax-exempt bond, they both the get $100 as income, but the person in the higher income tax bracket would benefit more since he would be paying a higher tax in an alternate investment.
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Simply put, tax-exempt funds are more attractive to investors in the higher tax brackets because munis allow them to invest their funds and get attractive returns without worrying about taxes. An alternate type of investment may get them higher returns, but they then will also be paying higher taxes for these high returns. Tax-exempt funds are less attractive to investors in lower tax brackets as they would be getting higher returns on regular bonds.
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Risk Factors of Investing in Tax-exempt Bonds
Although munis are issued and backed by government agencies, tax-exempt bonds are not free from risk. Tax-exempt funds carry interest-rate risk, credit risk, market risk and call risk. Interest-rate risk is the risk that the interest rates may change over the time-period of the bond. Although it will not affect the rate of return that an investor gets because of the locked-in interest rates, there is the risk that other investments would give a better rate of return than a tax-exempt bond.
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Credit risk of a tax-exempt bond is the risk that the principal may not repaid at the time of maturity or that interest payments may not be paid on time. There are rating agencies that helps the investor to determine the credit-worthiness of institutions that back the municipal bonds. Market risk is that a bond may increase/decrease in value due to the prevailing market condition. However investors need not worry about the market risk if they are not planning to sell the bonds in the secondary market. Sometimes agencies that issue the tax-exempt bonds may decide to repay the amount that they borrowed in part or in full. This is considered a 'Call risk' because it ends the income stream of investors sooner than they thought.
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Because of the tax-exempt nature and lower risks of municipal bonds, they give lower returns than other taxable securities. An investor looking to invest in tax-exempt bonds should fully understand the meaning and nature of municipal bonds and decide if it is a better choice of investment for him.
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Image Credit: dbking, http://www.flickr.com/photos/bootbearwdc/168551508/
- Weighing the Tax Benefits of Municipal Securities by Jason Van Bergen in Investopedia, http://www.investopedia.com/articles/04/072804.asp
- The Basics of Municipal Bonds, in nasdaq.com, http://www.nasdaq.com/investing/basics-municipal-bonds.stm