First, I would push back some on your premise. Yes investments add some complications to tax, but it needn't be much hassle.
As long as you stick to the mainstream -- US-based retail funds, or "normal" stocks and bonds (and ETFs and UITs and such) through a domestic brokerage --
they'll keep the needed records for you. Practically all have done so as a "customer service" for about two decades, after trading
and registration went fully electronic and made it cheap for them to do this, plus new rules phased in over the last few years
require they keep records and report to the IRS in a standard way with a copy to you on "1099 series" forms (1099-B, 1099-DIV, etc).
Shortly after the end of each year you'll get these forms, with specific instructions like "report the amount from box 2c on line X of 1040,
or line Y of 1040A, or section Z if you need to file Schedule D". And if you use tax return software, often it can get an electronic copy
of this information directly from the institution and plug everything in the right places automatically.
That said, tax-exempt bond mutual funds are one reasonable option, so to answer as asked, partly based on my own experience with some
Vanguard exempt bond funds over the years though not the specific one you mention:
Yes only dividends are exempt -- and only to the extent that they derive from exempt interest received by the fund on its holdings.
Normally this is all of it, but occasionally some muni bonds are determined not to be really public and thus don't qualify for exemption;
these are then called "private activity" bonds. Vanguard is pretty conservative/prudent and I've never experienced private activity income
from them, but they don't guarantee it will never happen. If it does it will be on your 1099 -- and I'm confident it won't be large.
(Caveat for completeness: a dividend may exceed the distributable income, perhaps because of tentative accounting
that turns out differently than projected. This is called "return of capital" and is not taxable when paid for any investment, but instead
reduces your basis and thus makes your later capital gain or loss more positive, so it works as a deferral not a real exemption.
But I've never seen ROC on a Vanguard fund.)
State income tax is separate if you are in a state that has an income tax. Interest on bonds from any state is exempt from Federal tax,
but only interest from the same state is exempt from (all?) state income taxes. VWLTX/VWLUX is a national fund, so only a small fraction
will be exempt for your state -- and the 1099 package will tell you the fraction. Vanguard also has about half a dozen state-specific muni funds
that are fully exempt on state tax if you live in that state. So do other major fund families.
Aside: VWLUX is "Admiral" class shares, which means a minimum balance of $50k. "Investor" class for smaller amounts is VWLTX.
In all(?) Vanguard funds Admiral shares have a lower expense ratio, and thus slightly higher return.
Other fund families almost always have similar premium classes for large investments.
Yes capital gains are taxable and they come in two ways. First, the fund realizes capital gains and losses on bonds sold or matured/called,
and just as its net interest income produces dividend distributions to shareholders like you, any net capital gain becomes a capital-gain
distribution; this is done in December when the (nearly) final totals for the year can be computed. This gain is categorized
as short-term or long-term or (usually) some of each based on whether the fund held the underlying items up to or more than a year,
regardless of when you held the shares on which the distribution was paid. Short-term gains are taxed at the same rates as other
"ordinary" income; long-term gains are taxed at lower rates (for Federal; states may vary). If you use tax return software (or your preparer does)
it will handle this, otherwise you (or they) must follow the 1040 instructions on filling out the correct one of a few worksheets.
If the fund has a net capital loss, you don't get a deduction now, but the fund carries it forward to cancel out gains in future years.
Gain distributions can indeed give you unexpected taxable income, although for muni bonds IME usually not much. Vanguard definitely, and
I'd expect others, do post projected capital gain distribution rates on their website a month or so before paying them, but that's still pretty close
to the end of the year. Long term bonds (muni or not) normally move in value more sharply in response to prevailing interest than shorter term bonds,
so if this worries you something like VWITX/VWIUX Intermediate-Term Exempt might make you feel safer, because the underlying holdings are less
likely to produce large capital gains or losses, at probably a slightly lower return on average over time. (And not state-specific.)
OTOH at present US interest rates are at historical lows (mostly because of the Fed) and pretty much everybody believes they will go up in the near future (although there is much disagreement over just when), which should make capital gains on bonds unlikely for a while.
Second, when you sell (aka "redeem") your shares, you realize a gain or loss equal to the value of the shares at the time you sell them,
minus their basis, which is basically the amount you paid to buy them, sometimes with subsequent adjustment(s). If you sell only part of your
shares there are some options on how to allocate the basis, but for mutual funds it is usual to use "average cost" and (again) the fund
will do this computation for you and put it on your confirmation and/or statement and 1099 forms. This time the gain or loss is categorized
as short-term or long-term depending on whether you held the fund shares up to or more than a year. If you have a net capital loss,
you deduct up to $3k from (other) income now, and carry forward any remainder against future years. (Contrast to the fund case above.)
The assets of the fund are never taxable. Nor are your shares, as an asset to you. Only the income.
