The Best Tax-Efficient Muni Funds Ratings delves into its database to find the top municipal bond funds.
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Editor's note: As a special feature for March,

is offering an ongoing series on everything you need to know about taxes. Today is part 16.

One of the best, and simplest ways to invest tax-efficiently is with tax-free municipal bonds. And thanks to the ever-opportunistic mutual fund industry, investors can now enjoy the benefits of diversification and professional bond management in the many hundreds of muni bond funds now available.

To identify muni funds that would appeal to the most tax-smart investors, Ratings trawled our database of bond funds that would likely appeal to the most ardent tax watcher.

So we came up with a list of municipal bond funds that meet the following criteria:

  • No capital gains paid by the funds in calendar 2006 or 2007 to date.
  • Returns on principal of less than 1% over the past 12 months. Gains in principal values could translate into capital gains distributions by the funds or as tax liabilities if a fund is sold at a profit.
  • Returns on principal not negative for the past 12 months -- declining principal erodes a fund's ability to maintain dividends.
  • Minimum initial investment of no more than $250,000.
  • Only funds with the very highest grade of A-plus from Ratings.

It's also important to note that although muni fund dividends aren't subject to federal income taxes, they can be taxed for capital gains, albeit at a preferential rate if they qualify as long term.

The eight that passed these stringent criteria in the table below provide an interesting sample of muni funds. Four are national municipal bond funds, while two others invest in single states, and are potentially free of state taxes as well.



SIT Florida Tax-Free Income Fund (SFLIX) is insured, so even though its current indicated dividend yield amounts to a relatively slender 3.38%, its ongoing stream of payments is guaranteed by a bond dividend underwriting firm.

And for those looking for a dividend yield that competes on a tax-adjusted basis with government and even high-grade corporate bonds, the high-yield -- currently 4.67% --

(NOTAX) - Get Report

DWS High Yield Tax-Free Fund passed all the above tests. It also has an easy-to-remember ticker: NOTAX.

Richard Widows is a financial analyst for Ratings. Prior to joining, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.