Instead of investing tax free in municipal bonds directly, you may want to consider investing in tax free municipal bond funds. The same attractive tax benefits found in municipal bonds are also passed along to investors investing in municipal bond funds.

What are municipal bond funds?

Municipal bond funds are mutual funds that invest in municipal bonds. Municipal bond funds are simply portfolios of municipal bonds, managed by professional mutual fund managers. There are many benefits as well as drawbacks in investing tax free in a portfolio of municipal bonds (a mutual fund) instead of investing in individual municipal bonds. Different municipal bond fund managers always try to find the best municipal bonds to invest in so you don't have to. You can simply look at the mutual fund ratings to see which are the best municipal bond funds.

Benefits of investing in municipal bond funds

For a low minimum initial investment, often as little as $1,000, these tax free municipal bond funds offer investors a high level of diversification and welcome relief from the daunting task of portfolio planning. Beyond their tax advantages, municipal bond funds also offer other important benefits:

• Tax free municipal bond funds offer enhanced diversification

Whether you are seeking to diversify your stock investments or your taxable bond investments, tax-free income municipal funds can be an effective tool for helping to enhance your portfolio's overall diversification.

• Tax free municipal bond funds offer added income

A tax free municipal bond fund investment many also provide you with more disposable income - either to spend on things you enjoy or to help meet ongoing expenses such as a child's college tuition

• Tax free municipal bond funds offer greater compounding potential

Tax free municipal bond funds offer you the option of reinvesting your interest income. Because that investing in municipal bonds income funds is tax free investing, you have more dollars working for you, maximizing your compounding potential over time.

A portion of the tax free municipal bond funds' income may be subject to the Alternative Minimum Tax (AMT). Consult your tax advisor for your individual circumstances.

Taxes aren't the only thing that can reduce the value of your investments. Inflation also erodes the value of your money - and purchasing power - over time. That's why it's important to select investments that have the potential to stay ahead of inflation. Municipal bonds have historically outpaced the rate of inflation in the long term, and have often outperformed various short-term investments as well.

Adding a municipal bond component (either municipal bonds or municipal bond funds) to your portfolio may also help protect it from the adverse affects of market volatility. Municipal bonds are generally less volatile than stocks and often perform differently under similar market conditions. A diversified portfolio that includes local municipal bonds therefore may achieve better potential long-term performance than one that does not. Keep in mind, however, that an investment in municipal bonds still entails risk.