Use a Tax Free Mutual Fund: How They Work

Look at the load. Some funds are load funds. That means they cost you money up front to buy, or cost you at redemption. The load is another methods of raising capital but it also is incentive for brokers to sell the funds. They make part of the load when you purchase a mutual fund. Even if the load is only at redemption, the broker makes money at the point of sale.

Before a tax-free mutual fund sells one share of the fund, they have to create a prospectus that tells all the basics about it. The prospectus shows the type of fund, fees and expenses, investment objective and strategy, limitations, risks and fund managers. Tax-free mutual funds use municipal bonds, tax-free bonds as their investment and other financial instruments. The information shows the grade of tax free bonds acceptable inside the mutual fund, the minimum investment in specific types of bonds and whether there are limitations on the state that create the tax free instruments.

Check to see the percentage of bonds subject to the AMT. The alternative minimum tax can add additional taxes to your bottom line. You need to make certain that the bonds in the fund don't put you in a situation where you have to pay alternative minimum taxes.

Purchase shares of the mutual fund through the company or on the stock market. Closed end mutual funds sell on the stock market because the fund company only creates a specific number of shares to raise money to invest. You have to trade your shares on the stock market. Companies create new open-ended fund shares daily, which you purchase and redeem through the company. This type of fund sells new shares to thousands of people daily and the fund managers buy more investments with the money from the sale, which create an even bigger fund.

Read the prospectus carefully and you'll see how the tax-free mutual fund makes their money. There are annual management fees that come out of the money before you even see a return. These pay the fund managers and the cost of buying and selling the bonds inside the fund. There are also 12b-1 fees on the interior o the fund. The 12b-1 fee is up to 1percent and pays for advertising. It also pays money to the broker and broker dealer who sell the fund as long as they are still the client's representatives. These payments are incentive to keep in touch with clients and give good service. There are administrative costs charged to the fund before you ever see the return.

Subtract the cost from the money the fund grew and you have the profit that the fund made. This money goes to you in the form of a return. Municipal bonds pay a little less because the IRS doesn't tax the interest. You get this as tax-free interest. They also make money when the price of the bond goes up, or sells at a premium. This comes as capital gain profit. Sometimes funds make money from bonds that the government taxes. You may have some of these distributed. The return that shows in the prospectus reflects the profit.

Look at the load. Some funds are load funds. That means they cost you money up front to buy, or cost you at redemption. The load is another methods of raising capital but it also is incentive for brokers to sell the funds. They make part of the load when you purchase a mutual fund. Even if the load is only at redemption, the broker makes money at the point of sale.