||Ask Dr. Don
Dear Dr. Don,
Would a short or intermediate tax-exempt mutual fund be a good place
to have money for an emergency fund for an investor in the 28-percent
Most financial planners recommend that households should keep three
to six months of expenses in an emergency fund for short-term cash
Conventional wisdom suggests that you don't want any liquidity
risk in an emergency fund because if you have to sell the investments
in a hurry, you may have to take a loss on the investment.
The problem with that advice is that you end up holding
a lot of low-yielding cash investments on the odd chance that you'll
need that money. See this Bankrate
article for additional thoughts on the wisdom of establishing
an emergency fund.
I'd rather see you put your emergency fund money into
bonds than a municipal bond fund. The Series I and Series EE
savings bonds charge a three-month interest penalty if you redeem
the bonds within five years of purchase, but you don't have to pay
state or local income tax on the bonds and you can choose whether
to pay federal taxes at redemption/maturity or annually.
There are no account fees, no transaction costs and
you may be able to use
the bonds later to pay for college expenses and not pay federal
income tax on the interest income. There's also no risk to principal,
which is important in an emergency fund.
See if you can readily tap your home's equity, get
a loan from your retirement account or cash-value life insurance
policy, or get a margin loan against your taxable investment portfolio.
Any of these lending sources will reduce how much you need readily
available in an emergency fund.
Other things you should consider for emergency preparedness: disability
insurance, major medical coverage, a durable power of attorney and
an umbrella liability insurance policy.
If you invest in municipal bonds issued by a government unit in
your state of residency, the interest income is often exempt from
state income taxes as well. Your broker or mutual fund representative
will be able to tell you if the interest income is tax exempt in
your state, or review this investor
The higher your marginal tax rate, the more sense
municipal bonds make in your portfolio. A 28-percent marginal federal
income tax rate is high enough to consider municipal investments,
but it's not high enough to categorically state that municipals
are right for you.
The litmus test for investing in municipal securities is to compare
the taxable equivalent yield on the municipal investment with the
yield on a taxable investment with similar risks.
Municipal yields are often compared on a tax equivalent
yield basis with U.S. Treasury securities. That's not an apples
to apples comparison because the U.S. Treasury securities have no
default risk, but it's a reasonable approximation when a municipal
bond is rated AAA or AAA insured. Use this calculator
to find the taxable equivalent yield on your municipal fund.
The problem with using after-tax equivalent yields
when deciding to invest in a municipal bond fund is that realized
capital gains are taxable vs. the tax-exempt interest income.
Also, when you buy a municipal bond fund, you don't
know what the fund will yield, unlike when you buy individual bonds.
One advantage to a bond fund besides professional management is
that transaction costs in the bond funds are minimal compared to
the costs associated with trading individual bonds.
-- Posted: Nov. 14, 2001