To add to Foolbar's (correct) comments:The interest earned on municipal bonds held by a municipal bond ("tax-exempt") fund are exempt from federal income taxes (although there are complications if you are wealthy enough to be subject to the Alternative Minimum Tax). Any capital gains (or losses) from the fund buying of selling bonds are subject to capital gains taxes (or losses), which is also the case if you sell your shares in the fund for more than you paid (you get capital gains tax loss, if you sell for less). Some municipal funds also hold a portion of U.S. Treasury bonds, whose interest would be taxable on your U.S. Taxes.The easiest way to decide which is best is to divide the yield on the "tax-exempt" fund you are looking at by (100 minus your tax bracket)% and compare with the yield on an analogous taxable fund. So, if you are in the 27% tax bracket, you would divide by 73%; in the 30% bracket by 70%. Don't forget tax brackets will be going down by a couple of percentage points over the next few years (unless, of course, they don't). Be sure you compare a long term tax exempt fund's yields with a long term taxable fund's, intermediate term with intermediate, short term with short term. The last time I ran the numbers on Vanguard's funds, the tax-exempt long term and intermediate funds ran neck and neck with the analogous corporate fund for someone in the 30% tax bracket; in the 27% bracket, the corporate funds won.However, you also need to pay attention to your state income taxes. Municipal bonds issued in a state are (I think this is universal, but I'm not sure) exempt from state income taxes as well as federal. So, if you have a high state income tax, a state specific municipal bond fund makes a big difference: add your state income tax to you federal tax bracket and divide into the yield to do the comparison (e.g, if you have a 6% state income tax and are in the 27% tax bracket, you would divide yield by 67%).
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