Double Tax-Free Funds Find Favor in California

Always looking to save taxes, California investors have sparked a boom in mutual funds holding tax-free bonds issued in this state.

But these so-called California double tax-free funds may not necessarily be the best choice for you. And they are not all the same.

Double tax-free funds have become one of the nation’s fastest growing fund groups in recent years. Assets in the funds have ballooned to $14.76 billion as of June 30, compared to only $3.2 billion in January, 1985, according to Lipper Analytical Services of Summit, N.J.

Some 51 California tax-free funds now exist, nearly triple the 19 of 3 1/2 years ago. (That number excludes California tax-exempt money market funds, the tax-free version of popular money market funds.)

These funds are appealing for a simple reason: Their interest income is free from both federal and state income tax as long as you are a California resident.

Their yields are somewhat lower than on funds with tax-free bonds from throughout the nation, which are only exempt from federal tax. But if you are in a high tax bracket in a high tax state such as California, the after-tax yield on double tax-free funds can be superior to that from single tax-free funds.

Double tax-free funds also can be superior to Treasury securities, certificates of deposit or other taxable investments if you are in a high bracket. For example, many California funds with longer maturities are now yielding more than 7%. Because of the tax savings, that’s equivalent to a taxable yield of 10.5% if you’re in the 28% federal tax bracket and 8% state tax bracket, and 11.5% if you’re in the top 33% federal bracket and 9.3% state bracket.

And California funds are considered relatively safe, because they typically hold a diversified portfolio of bonds so that defaults in any one issue won’t significantly hurt the overall yield. That is safer than buying individual issues on your own.

But the funds are not for everybody. If you are in the 15% tax bracket--as most people are--these funds are not a good choice. You can earn more in a taxable investment.

And although the funds might seem similar at first glance, in reality there is a wide variation between their maturities, costs, risks and returns.

Some fund families, such as Vanguard, T. Rowe Price, Dreyfus, Benham, Scudder and Fidelity, offer California double tax-free funds that have no “loads,” or sales commissions. Paying such loads, which on other funds run more than 4%, will significantly erode your net return if you don’t hold the fund very long.

And while yields seem similar between funds, total returns--yield plus fluctuation in bond values--vary considerably, particularly on funds with longer maturities. That’s because longer-term bonds fluctuate more in value, falling when interest rates rise and gaining when interest rates fall.

Accordingly, the top performing California tax-free fund for the 12 months ended May 31 was Alliance Tax-Free Income California, with a total return of 10.55%. By contrast, the largest state tax-free fund, Franklin California Tax-Free Income, returned only 6.35% in that same period.

Some funds offer somewhat higher yields in exchange for a higher risk of defaults. On the other hand, some funds, such as Vanguard California Tax-Free Insured, offer greater safety by buying bonds that are privately insured from losses due to default. However, insured funds yield as much as a third to a half percentage point less than uninsured funds.

Ralph G. Norton, editor of Muni Bond Fund Report, a Huntington Beach newsletter, says such insurance is really not necessary if you stick to funds that are managed by reputable fund companies.

“You already have diversification and portfolio management,” he says, so you don’t need to sacrifice that half percentage point in yield to get insurance. The insurance, he adds, still doesn’t protect you from price volatility.

To pick the right fund for you, determine how much volatility and risk you are willing to take.

If you think interest rates are headed lower and are willing to take some volatility in the price of your fund shares, then a longer-term fund may be better.

On the other hand, if you think rates are headed higher, or you aren’t sure and don’t want to take any chance, then stick to shorter-term funds.

The shortest of all are so-called tax-free money market funds. Like taxable money market funds, their share values never fluctuate, always staying at $1.

William E. Donoghue, publisher of Donoghue’s Moneyletter and a leading expert on money market funds, recommends Franklin California Tax-Exempt Money Fund, with a seven-day average yield of 5.1%, historically among the top-performing tax-free money funds nationwide.

However, if you want to switch money from your tax-free money fund into bond or stock funds within the same fund family, Franklin may not appeal to you because it charges loads on its bond funds.

An alternative, Donoghue suggests, would be Vanguard California Tax-Free Money Market Fund, a no-load fund with a seven-day average yield of 5.4%.

Vanguard has one of the most diversified lines of stock and bond funds, and its annual expenses are considered the lowest among major fund groups.