Investors who buy individual municipal bonds receive regular interest payments. When your bond matures, the issuer returns your principal. If you buy shares in a municipal bond mutual fund, the fund owns the bonds and receives the interest payments from the bond issuers. Mutual fund managers pass these interest payments on to investors in the shape of dividend payments. You have the option of reinvesting your dividends in the municipal bond fund, although doing so could add to your tax burden in the long run.
Municipal bond interest payments are typically exempt from federal income tax, although some bonds related to joint public and private projects are taxable. Since dividends on municipal bond funds are derived from interest payments, these dividends are also typically tax-exempt. In contrast, dividends from corporate bond funds are taxable, as are interest payments on most types of individually owned corporate, international or mortgage-backed bonds. You can reduce your taxable income by investing money in tax-deferred accounts, such as employer sponsored 401k plans while supplementing your income by investing in tax-exempt municipal bond funds. The higher your tax bracket, the greater the appeal of tax exempt bonds.
When dividend payments are disbursed from a taxable mutual fund, shareholders have to pay taxes on those dividends. Choosing to reinvest your dividends in the fund does not prevent you from having to pay tax. You never physically take possession of the dividend proceeds, but from a tax perspective a reinvestment involves two stages; the disbursement and then the reinvestment. The same rules apply to municipal bond funds, so reinvesting has no impact on your taxes in the current year even if your dividends are partially taxable because you pay the tax whether you accept the dividend or choose to reinvest it.
The value of a mutual fund can rise over time; this often occurs if interest rates fall because the bonds in the fund become more valuable. When you sell shares in a municipal bond fund, you have to pay taxes on your capital gains. You calculate your capital gains by deducting the price you paid for the shares, known as the cost basis, from the sale price. If you sell shares that you have owned for a year or less, then you pay ordinary income tax on your capital gains. If you sell shares after a year or more, then you pay long-term capital gains tax, which, as of the time of publication, amounts to 15 percent. Therefore, you potentially add to your long-term capital gains liability if you reinvest dividends in municipal bond fund shares.
Some people argue that you miss out on the true benefit of tax-exempt bond funds if you reinvest your dividends because you do not actually get to use your tax-free earnings. In fact, since municipal bond funds are subject to capital gains, some people invest their tax-exempt dividends in other kinds of taxable mutual funds that offer better growth potential.
On the other hand, you can change you distribution election at any time. Every share that you buy with reinvested dividends creates additional tax-exempt income for you. You can start to draw on this ever-expanding income at some future date by changing your dividend election so you no longer reinvest your earnings.