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I'm saving some money, probably for a down payment house, and I'd like it to earn a bit more return than it would just sitting in cash. I max out my Roth 401(k) and my Roth IRA, so any additional savings will be outside tax-sheltered accounts. I found a federal tax-free bond mutual fund with an expense ratio of 0.55% that invests mostly in short-term municipal bonds (with maturities less than 4 years), and I like that I won't pay federal taxes on the dividends.

Looking at the price history (I know it's no sure predictor of future performance), the NAV has been roughly between $10.4 and $10.7. I'm willing to take the risk of losing a little of the principal if it means I can earn a bit of federal-tax exempt interest on the fund.

Apart from possibly losing some of the principal if/when interest rates rise, which they'll definitely do sometime in the next year or so, any other risks to doing this?

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    +1 to littleadv, but why would you "risk" price fluctuations when your time period is that short? Stick it in the bank, IMHO. – Pete B. Apr 29 '14 at 17:12
  • @PeteBelford I'll second Pete's point. You don't want to run the risk of something cataclysmic happening just when you need the money, with the end result being that you can't afford the down payment on the house you want. Also, this question talks a bit about saving/investing in the short term, so you might find that information useful. – John Bensin Apr 29 '14 at 18:55
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The "risk", other than losing principal (especially when rates go up) is capital gains.

As with any mutual fund, this one might need to sell assets for cashflow. In which case the taxes on the sales are shifted to the investors. So you may end up with the fund losing value due to price fluctuations, yet you'll have capital gains (probably with a significant short term part since the maturity periods are relatively short) to pay taxes on. To what extent that may happen depends on the fund's cashflow (influx of money vs. withdrawals).

Capital gains reduce your basis (since no money is actually distributed), but if you hold the fund for more than a year - you lose the difference between the short term and the long term tax for the short term portion of the gains.

  • so I guess I want to balance the tax-free federal dividends with the possible capital gains that come either from appreciation of principal or the cap gains generated throughout the year, right? – Michael A Apr 29 '14 at 15:22
  • @BenK yes. Although if the rates don't change significantly I don't expect a wave of withdrawals, so I wouldn't worry about that all that much. – littleadv Apr 29 '14 at 15:22
  • right, although everything I read says that rates are expected to rise sometime in the next few years because the fed wont be buying bonds any more (I know theyre not buying munis but still) and wont be keeping interest rates are 0 for ever – Michael A Apr 29 '14 at 15:24

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