A mutual fund is created by "pooling" investors' funds to allow them to take advantage of diversification and professional management. Although many mutual funds are taxable, some mutual funds offer tax-exempt income in addition to the other advantages of the mutual funds approach.
Mutual funds that invest in municipal bonds may pay exempt interest dividends. Exempt interest dividends retain their exempt character, and are generally not subject to federal income tax but may be subject to the AMT. These dividends are also exempt from state and local tax if you are a resident of the state in which the fund invests. The fund will notify you about the percentage of dividends that are exempt from state taxation. You may be subject to tax on dividends attributable to capital gains from the sale of tax-exempt securities by the fund. In addition, you may be subject to tax at ordinary income rates on dividends attributable to the sale of tax-exempt bonds that were purchased by the fund at a market discount. Also, as previously noted, although the income in a tax-exempt trust and tax-exempt mutual fund is generally free from federal taxes, any capital gains resulting from the sale of the trust or mutual fund shares will be subject to taxes.