Municipal bond fund investors have two choice:
* Invest in a national fund. You probably won’t owe federal income tax but you may owe state (and even local) income tax.
* Invest in a single state fund. If you invest in a fund that holds only bonds issued in your state, you generally can avoid all income tax on the interest you receive.
You have to decide whether the tax saving is worth the risk of relying on bonds issued in a single state.
Suppose, for example, Ann Green lives in Virginia and owes state income tax of 5.75%. She invests $50,000 in a bond fund yielding 4% so she receives $2,000 in annual income from the fund.
Ann owes nothing to the IRS but she’ll owe $115 to Virginia: 5.75% times $2,000. After paying that tax, Ann’s after-tax income would be is $1,885. If she had invested in a Virginia single-state fund and the yield was also 4%, Ann would have kept all $2,000 without owing any tax.
The question, then, is whether buying an in-state fund is worthwhile. As you can see, an investor who puts $50,000 into a single-state municipal bond fund would be ahead by $115, in this example. Is that difference in income worth taking the risk that your state’s economy will deteriorate, lowing the value of your bond fund shares? Economic weakness in your home state could drive down the prices of bonds issued there.
