It’s true that the tax bill has taken away some of the lusters of tax-exempt funds. Yet this does not mean you should avoid them. The fact is that these investment vehicles still have quite a few advantages.
First of all, if you are in a high-tax bracket, you will probably be able to pocket more of your returns. Keep in mind that municipal bond interest is completely tax-free on your federal return.
What’s more, if you live in a high tax state -– such as New York or California –- you can also get an exemption from state taxes. And in some cases, city and local taxes may able be tax-free.
There are certainly risks. For example, some states and cities are suffering from fiscal troubles, which could impact the value of the bonds. Then again, with disciplined portfolio managers -– which tax-exempt funds can provide -– you should be able to mitigate these issues. And of course, there is the power of diversification.
So then what are some of the tax-exempt funds to consider? Well, let’s take a look at three:
Tax-Exempt Funds No. 1: Vanguard California Long-Term Tax-Exempt Fund
Even though yields have been rising, they are still relatively low. This is why it is a good idea to consider funds that have low expense ratios.
No doubt one of the standouts is Vanguard. The company runs a highly efficient operation and generally relies on indexes, which greatly lowers the costs.
Vanguard also has a set of solid tax-exempt funds, which range from intermediate to long-term bonds.
Just look at the Vanguard California Long-Term Tax-Exempt Fund Investor Shares (MUTF:VCITX) fund, which has $4 billion under management. Even though the portfolio manager is leaving, his replacement is highly qualified. It is also important to keep in mind that the fund has a group of other investment experts and analysts.
For the most part, VCITX takes a conservative approach to its investments. Note that over 77% of the portfolio consists of bonds that are rated AA or higher.
But this hasn’t muted the gains. Over the past decade, the average annual return was about 4.64%.
And yes, the expense ratio is rock-bottom, at only 0.19%.
OK then, so what about states other than California? Vanguard does have you covered. Here some other funds: Vanguard New York Long-Term Tax-Exempt Fund Investor Shares (MUTF:VNYTX), Vanguard New Jersey Long-Term Tax-Exempt Fund Investor Shares (MUTF:VNJTX) and Vanguard Massachusetts Tax-Exempt Fund Investor Shares (MUTF:VMATX).
Tax-Exempt Funds No. 2: T. Rowe Price Tax-Free High Yield Fund
Many tax-exempt funds take a conservative approach to their portfolios. And this makes a lot of sense. Investors in these kinds of funds are often looking for relatively stable yields.
But what if you want to get more aggressive? There are some funds that can do just that.
One to consider is the T. Rowe Price Tax-Free High Yield Fund (MUTF:PRFHX) fund, which has $5.6 billion under management. As for the portfolio, nearly 77% of it is made up of bonds with ratings of BBB or lower.
This may seem too risky. But the portfolio manager, James Murphy, has a great track record. In fact, he has been at the helm of the fund since 2001. In other words, he has been tested with different types of market environments. Murphy also has a team of analysts that pour over the data and ferret out the risks.
The expense ratio is a bit on the high side, at 0.69%. But this is to be expected for a fund that has active management, especially in a category that requires lots of research.
As for the average annual return for the past 10 years, it was 5.36%.
Tax-Exempt Funds No. 3: Fidelity Municipal Income Fund
If you live in a state with low or no income taxes, then you should look for a national muni fund. This will not only be more tax efficient but also allow for more diversification as the fund can invest in all 50 states.
A highly-rated fund in this category is the Fidelity Municipal Income Fund (MUTF:FHIGX), which has $6.3 billion under management.
This fund has also seen its portfolio manager leave. But the good news is that he will be replaced by two-top notch managers, Mark Sommer and Kevin Ramundo, who have extensive experience with muni bonds. What’s more, there is a group of analysts to provide support.
The investment approach for the FHIGX fund is on the conservative side. To this end, there is a focus on those kinds of muni bonds that have consistent income, say from healthcare or transportation.
The expense ratio is also at a reasonable level, 0.46%, and the return on the fund is an attractive 4.46% for the past 10 years.
Tom Taulli is the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.
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