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I'm saving some money, probably for a down payment house, and I'd like it to earn a bit more return than it would just sitting in cash. I max out my Roth 401(k) and my Roth IRA, so any additional savings will be outside tax-sheltered accounts. I found a federal tax-free bond mutual fund with an expense ratio of 0.55% that invests mostly in short-term municipal bonds (with maturities less than 4 years), and I like that I won't pay federal taxes on the dividends.

Looking at the price history (I know it's no sure predictor of future performance), the NAV has been roughly between $10.4 and $10.7. I'm willing to take the risk of losing a little of the principal if it means I can earn a bit of federal-tax exempt interest on the fund.

Apart from possibly losing some of the principal if/when interest rates rise, which they'll definitely do sometime in the next year or so, any other risks to doing this?

John Bensin
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Michael A
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1 Answers1

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The "risk", other than losing principal (especially when rates go up) is capital gains.

As with any mutual fund, this one might need to sell assets for cashflow. In which case the taxes on the sales are shifted to the investors. So you may end up with the fund losing value due to price fluctuations, yet you'll have capital gains (probably with a significant short term part since the maturity periods are relatively short) to pay taxes on. To what extent that may happen depends on the fund's cashflow (influx of money vs. withdrawals).

Capital gains reduce your basis (since no money is actually distributed), but if you hold the fund for more than a year - you lose the difference between the short term and the long term tax for the short term portion of the gains.

John Bensin
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littleadv
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