Florida Muni Funds Draw Investors Despite Minimal Tax Benefit

Income from the funds is tax-free. But there's no state income tax in Florida.
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Having poured more than $8.6 billion into 24 Florida municipal bond funds, the state's investors clearly have a healthy appetite for them. Whether they need them is another question entirely.

Muni investments generate income that is exempt from federal taxes. The idea behind investing in a muni fund focused on your state is that you also avoid state income taxes in exchange for less diversification and usually a less competitive yield.

But Florida has no state income tax. The continuing popularity of the state's muni bond funds demonstrates that, for some investors, emotional factors can override other issues. And when that happens, fund companies and brokers aren't shy about indulging investors' urges.

Even the

Vanguard Group

, a harsh critic of ill-conceived funds, offers a Florida muni fund.

Florida does have an "intangibles" tax on invested assets that might make muni funds attractive for very high-net-worth investors. But that tax was recently reduced to $1.50 for every $1,000 of invested assets over $100,000 from $2. Residents with $20,000 to $100,000 in invested assets pay even less -- $1 per $1,000 in assets. For a resident with up to $100,000 invested, the tax amounts to $80 annually at most, according to a spokesman for the

Florida Department of Revenue

.

Given the limited tax savings, why invest in Florida muni funds at all? Why not choose a national muni fund, which at least offers diversification among the issues of a variety of states and, typically, a more competitive yield?

"It's a reasonable question. You're not really getting paid a yield premium, and Florida is not like California, New York or Massachusetts, where higher taxes are a real motivator," says Dianne Sales, a muni fund manager at

John Hancock Funds

, which does not have a Florida-specific offering. "You've got to look at what offers the highest after-tax return -- the Florida fund or a national muni fund. A better-educated investor might really wonder if it's in the best interest of their portfolio

to invest in a Florida muni fund."

Stella Wong, co-manager of the

(FRFLX) - Get Report

Franklin Florida Tax-Free Income fund, says critics of Florida muni funds often overlook the state's diversified economy and high-quality credit issues. And don't forget the intangibles tax, she says. "Taxes are taxes. They're dollars out of your income."

But another reason for these funds' appeal has little to do with dollars and sense. Wong and another Florida muni fund manager say the value Floridians place on investing in their own backyard shouldn't be overestimated.

"Investors in Florida have a real desire to invest in local projects. They feel more comfortable investing in their area, in towns that they know," says Wong, whose fund is typically sold by brokers and is the largest in the category, according to

Lipper

, with assets of well over $1 billion.

Indeed, the number and asset size of Florida muni funds easily dwarfs those available to residents of the other income-tax-free states. Texas, for example, has just seven state muni funds, with just over $400 million in total assets.

"You root for your home team," says Reid Smith, co-manager of the

(VFLTX)

Vanguard Florida Insured Long Tax-Exempt fund. "They can look in their annual report and see the hospital down the street."

That said, Smith doesn't dismiss the higher risk associated with focusing on a single state's muni issues. A natural disaster or a major economic blow to the state could affect many of the credits in the portfolio. He notes that adding insurance from a non-Florida firm helps his fund and other insured Florida funds reduce this risk.

State pride and risk control aside, how does Vanguard justify offering a Florida muni fund?

"Florida residents have voted with their dollars," Smith says. "We had many investors asking us for a Florida muni fund, and in response to that demand, we started our fund in 1992." It's now the second-largest fund in the category, with assets of $896 million, according to

Morningstar

.

If Florida muni funds can't be justified by sound investment strategy, are there other reasons for offering them? Wong thinks so. "We've got more than one and a half billion reasons," she says.

Do you have money in a Florida muni fund? If so, why?

Florida is a good investment, and I want to support public works in my state.

I need to reduce my intangibles tax bill.

I didn't know any better.

My broker put me in the fund.