Tax-free investing.

Municipal bond funds may be a cure for tax headaches

As you work on your tax return for 2000, you may be surprised to see how much taxable investment income you incurred last year--and how much in taxes you'll pay this year. If that's the case, consider switching some of your fixed-income investments to municipal bond funds, which pay tax-exempt income.

"The first step," says Kathleen Stepp, a CPA and financial planner with Stepp & Bothwell, in Overland Park, Kansas, "is to determine whether your tax bracket is high enough to make municipal bonds appropriate. If you're in a 15% bracket--the lowest federal bracket--then I wouldn't advise investing in tax-exempt bonds."

In 2000, single taxpayers with up to $26,250 in taxable income were in the 15% bracket, which jumps to $43,850 for joint filers. Above that, tax brackets range from 28% to 39.6%, where municipal bonds may make sense. "The higher your bracket," says Stepp, "the greater the benefit you'll get from individual municipal bonds and muni bond funds."

Still, how can you choose among the 1,845 municipal bond funds tracked by Chicago-based Morningstar Inc.?

National vs. single-state funds. Start by choosing between funds that hold bonds issued around the country and funds with bonds issued only in your state, says Eric Jacobson, a senior analyst at Morningstar. National funds provide diversification, while single-state funds usually deliver income that's exempt from state (and perhaps local) tax as well as federal tax. Thus, after-tax income probably will be higher from a single-state fund. "Single-state funds are riskier," explains Jacobson, "because they can lose value more easily if your state's economy turns down sharply." He adds that many people are attracted by the diversification of national funds, but investors in high-tax states such as California, New York, and Massachusetts may prefer single-state funds.

Short- vs. intermediate- vs. long-term bonds. Some muni funds hold bonds maturing in a few years while others have average maturities of 10 years, 20 years, or more. "Longer-term funds usually have higher yields and may provide greater long-term returns," says Jacobson, "but they have more risk too. If interest rates go up, long-term funds probably will lose the most value." That is, a fund with a share price of $20 might fall to $19 or $18 or go even lower, if rates rise. "I prefer short-term muni funds for clients who will need the money fairly soon, perhaps for a tax payment or a college bill," says Stepp. "For longer-term needs t probably would recommend individual bonds. If you buy and hold individual bonds until maturity you know that you'll get your money back."

High-yield vs. high-quality funds. Like corporate bonds, municipals include junk bonds as well as highly rated issues. As you'd expect, junk muni funds pay higher yields but they pose greater risks. In late 2000, for example, Eaton Vance National Municipals Fund (EVHMX) was yielding 5.6%, according to Morningstar, while its sister, Eaton Vance Municipals Trust II: Eaton Vance High Yield Municipals Fund (ETHYX), was yielding 6.5%. On a $50,000 investment, that would be an extra $450 in interest per year. Extra income is appealing but there's no free lunch. "High-yield muni funds may have inherent risks that are not apparent," says Jacobson. "If they hold bonds that are not frequently traded, for example, such funds could experience volatility not related to any fundamental bond traits."

"Look for a fund with an experienced manager, a good record, and very low expenses," says Richard Hammel, managing partner at Hammel Financial Advisory Group in Nashville, Tennessee. For example, Vanguard Insured Long-Term Tax-Exempt Fund (VILPX) has an expense ratio of 0.20% (on a $50,000 holding, your expenses would be $100 per year).

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