If you are in a higher income tax bracket and looking for a way to significantly reduce your tax burden, tax exempt bond funds may be a solution. Tax exempt bond funds are also referred to as municipal bonds, and the money you earn from your investment in these bond funds is typically tax free at both the federal and the state level.

Investing in tax exempt bonds does carry its share of risk, including interest rate risk, credit risk, and income risk.

Interest Rate Risk

You sustain more risk as the length of maturity of the bond increases. This is because the share prices for tax exempt bonds share an inverse relationship with interest rates, decreasing as interest rates increase and increasing when interest rates decrease. The longer you hold the bond, the more likely it will be to assume risk from fluctuating prices as interest rates change.

Just because you are buying bonds from a city, government, or municipality does not mean you are necessarily reducing your credit risk. In fact, a city or other government issuer of a bond can default and fail to make the principal and interest payments on the bond. Your credit risk can be lessened by investing in a tax exempt bond fund that invests in a broad range of bonds from different issuers.

As with any investment, there is the risk that you will not only not make money on the investment but that you will also lose the income you invest. Tax exempt bonds are safer than some other investment forms, but you should make the investment with the idea that it is a longer-term investment. The income risk will be higher with short term funds, with risk reducing with longer-term tax exempt funds.

Determining Whether or Not Tax Exempt Bond Investing is Right for You

This type of investment is not right for everyone at every income level. In fact, it is specifically targeted to those in higher tax brackets who are in need of investments that will reduce their tax burden. It would not make sense, for example, for a 401(k) fund to invest in an exempt bond fund, because the tax savings already enjoyed by the 401(k) would not allow for any measurable benefit. However, if your federal income tax bracket is higher than 15% of your income, exempt bond fund investing may help you reduce your taxable income.

When choosing the right bond fund to invest in, you need to determine which fund will provide you with the highest yield after taxes considering your specific tax bracket. To determine that, you would need to measure what the results of investing in the tax exempt fund would provide versus an investment in a taxable mutual fund or other investment. If the exempt fund does not result in fairly significant increases in your after-tax income, it is probably not the right investment for you.