Taxable vs. Municipal Bond Funds

Many investors are often discouraged by the apparently lower yields offered by municipal bond funds when compared to bond funds paying taxable interest dividends.

However, if you have to pay federal, state, and/or local taxes on the interest income distributed to you by taxable bond funds, a bond fund that invests in municipal bonds may actually generate more net interest income than a taxable bond fund with a higher stated yield.

Note, however, that interest dividends paid by a municipal bond fund may be taxable under the federal alternative tax (AMT) system if the bonds held by the fund are issued to cover the costs associated with certain "private activity" projects, such as housing projects, hospitals, certain types of airport expansion projects, and/or industrial parks. To find out if you might be subject to the AMT, visit Alternative Minimum Tax (AMT).

Compare $10,000 Invested in Municipal and Taxable Bond Funds

This hypothetical example compares $10,000 invested in a bond fund paying interest dividends exempt from federal income taxes and a bond fund paying interest dividends taxable at the federal level. In the example, investors in the 28% or 33% federal income tax bracket would have ended up with more after-tax interest income from the municipal bond fund even though its yield was lower.

These hypothetical examples are not intended to predict or project investment performance. Your own results will vary. State and local taxes, if any, fees, and expenses are not taken into account. If they were, certain results would be lower. Municipal bond funds normally seek to earn income and pay dividends that are expected to be exempt from federal income tax. If a fund investor is resident in the state of issuance of the bonds held by the fund, interest dividends may also be free of state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes.

A taxable-equivalent yield can help you compare taxable and municipal bond funds. The taxable-equivalent yield is an estimate for a specific tax rate of what a taxable bond fund would have to yield to give you the same after-tax yield as a municipal bond fund. The calculation does not, however, take into account the impact of any federal or state alternative minimum taxes on taxpayers receiving municipal bond income.

The following formula will help you to estimate the taxable-equivalent yield for a given municipal bond based on your federal income tax rate. Note that interest dividends paid by municipal bond funds may also be exempt from state and/or local taxes. Factoring in the exemption at the state and/or local level would have the effect of increasing the taxable equivalent yield further.

The amount it would be increased depends on whether you take an itemized deduction for state and local taxes, your state of residence and any applicable deduction limitations. If you take an itemized deduction on your federal return for such taxes, the formula below should not be used to calculate the impact of state and/or local tax exemptions. However, if you don't itemize such taxes, and the yield of the municipal bond you are considered would be exempt from your state's income taxes, you could add the state (and local) tax rate to the federal rate in the formula below to get a TEY that reflects both tax rates.

Yield of Municipal Bond Fund
	=	Your taxable-equivalent yield
1.00 - your federal income tax rate

Your federal income tax bracket	Is a municipal bond fund appropriate?
15%	Unlikely
25%	Likely
28%	Very likely
33%	Highly likely
35%	Highly likely

Keep in mind that municipal bond funds are usually not an appropriate holding within tax-advantaged accounts (such as IRAs and 401(k) plans).

Municipal bond funds normally seek to earn income and pay dividends that are expected to be exempt from federal income tax. If a fund investor is resident in the state of issuance of the bonds held by the fund, interest dividends may also be free of state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes. Investing in municipal bond funds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. Fund shareholders may also receive taxable distributions attributable to a fund's sale of municipal bonds. Fund redemptions, including exchanges, may result in a capital gain or loss for federal and/or state income tax purposes.

The bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a debt security to decrease.

Information provided is general and educational in nature. It is not intended to be, and should not be construed as, legal or tax advice. Fidelity does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Consult an attorney or tax advisor regarding your specific legal or tax situation.


	Fixed Income Glossary


	Taxable Bond Funds
	These funds invest in U.S. government and government agency bonds, mortgage-backed and asset-backed bonds or bonds issued by corporations. View Fidelity Taxable Bond Funds.

	Municipal Bond Funds
	These funds invest in bonds issued by state governments and municipalities. Interest dividends paid by municipal bond funds are generally expected to be federal income tax-free and may be state income tax-free if the funds own bonds issued by the state in which you live. View Fidelity Municipal Bond Funds.