What Is It?
A state tax-exempt bond fund is a municipal bond fund that invests exclusively in debt instruments issued by a particular state. A New York tax-exempt bond fund, for instance, is a fund holding only bonds issued by or within the state of New York. For residents of the state that issues the bonds, income from the bond fund is typically free from both federal and state income tax. Residents of non-issuing states do not receive the state tax benefit (although they do enjoy the federal tax benefit) unless they live in a state that does not impose income tax.
Tip: There are state tax-exempt bond funds for almost every state in the United States.
Note: Municipal (tax-exempt) bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance. As with any mutual fund, before investing, you should carefully consider the fund's investment objectives, risks, fees, and expenses, which are included in the prospectus available from the fund. Read it carefully before investing. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
Income Tax Benefits
The state income tax advantages (described above) can be the greatest strength of state tax-exempt bond funds. Moreover, fund income enjoys the same federal income taxation advantages as municipal debt generally. The tax savings provided by this tax-exempt treatment can significantly reduce a resident's total tax bill. In general, the higher your tax bracket, the more attractive the tax benefits become.
Caution: If you are subject to the alternative minimum tax (AMT), you must include interest income from certain municipal securities in calculating the tax unless the securities are specifically exempted from the AMT.
Caution: Any capital gains earned by the fund are subject to tax. Capital gains tax may also be imposed when you sell shares in a state tax-exempt bond fund.
Tip: If you live in a local municipality (e.g., a city or town) that levies its own taxes, a portion of your fund income may avoid those taxes as well. This can happen if some of the bonds in your fund's portfolio were issued directly by your municipality.
May Carry Lower Risk than Some Other Bond Funds
Because most of the bonds they hold are issued by state governments, state tax-exempt bond funds are generally considered lower-risk investments. However, before investing, carefully consider the fund's investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing, as you would with any mutual fund.
Caution: As with all bond funds, a state tax-exempt fund never matures like an individual bond and therefore doesn't offer the same assurance that your principal will be returned to you at some fixed future date.
State tax-exempt bond funds, like other bond funds, typically seek to provide current income. If you don't need the income currently, you can reinvest dividends in the fund, use them to make other investments. Also, that income may help balance other, more volatile investments in your portfolio.
Caution: Bond holders will receive income unless the bond issuer defaults. Investments offering the potential for higher rates of return also involve a higher degree of risk. Rates of return will vary over time especially for long-term investments.
Less Diversification than Other Tax-Exempt Funds
Even though these funds may carry lower risk than bond funds generally, the risk is generally more concentrated than with other municipal bond funds. That's because the fund's holdings are limited to the bonds of one state. If a state is heavily dependent on an industry that experiences an economic downturn, its finances (and those of the cities and towns in it) could be at greater risk of struggling to meet debt payments. In contrast, other municipal bond funds may offer greater diversification and more diluted risk by investing in bonds issued by multiple states.
Generally Modest Returns
The return on a state tax-exempt bond fund depends on several variables that affect municipal bond yields, including local economic factors and quality ratings assigned to specific bonds. Also, as a result of the tax advantage, returns are expected to be lower than with many other types of funds. However, depending on an investor's tax bracket, the tax advantage could mean a net return that is better than that of a taxable bond fund.
Interest Rate Risk
As with any bond investment, state tax-exempt bond funds are vulnerable to interest rate risk.
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