Invest in Tax-free Mutual Funds

One of the down sides of investing in mutual funds can be the federal and state taxes associated with them. While regular taxable mutual funds invest primarily in government agency securities, CDs, U.S. Treasury securities, bankers' acceptances and the like, tax-free mutual funds are more commonly money market funds that put their money in shorter-term debt obligations issued by entities that are exempt from federal taxes.

Decide on your investment goals and be sure that tax-free mutual funds are the best way to meet those goals. Tax-free mutual funds help you avoid paying taxes on your principal's interest; however, there are often early withdrawal penalties that can hit you hard. Tax-free mutual funds work best if you have a sum of money you are sure you will not need access to for some time.

Find out whether your state permits tax-free mutual funds as an investment choice. The issue of state tax exemptions varies from state to state.

Ask your financial advisor for his or her advice on the most reputable tax-free mutual funds.

Request the prospectus for the tax-free mutual funds that most interest you.

Read each prospectus carefully.

Check the risk rating of each fund you are considering on the Morningstar website.

Choose the best tax-free mutual fund for your needs and make your investment through your financial advisor, or directly through the fund, if allowed.

Tips & Warnings

• Start at the source: if you like the idea of investing with a specific financial company, ask if they offer tax-free mutual funds.
• Look for tax-free mutual funds that are exempt from both federal and state income tax.
• Be aware that tax-free mutual funds are, in general, designed for high net worth individuals.
• Be aware that the trade-off for tax-free mutual funds is that most have a lower yield than regular mutual funds.
• The tax-free component of these mutual funds does not necessarily apply to the issue of capital gains. Check with your financial advisor before you invest.
• Don't expect to find tax-free mutual funds available within your IRA or pension fund. They are not offered for these types of investments.