Municipal bonds have one big selling point: tax-free income. But as some investors are now finding out, their once tax-free municipal bond funds could come with a nasty state tax bill.

Fund companies including big firms such as BlackRock, Eaton Vance and J.P. Morgan are quietly taking funds that own municipal bonds of just one state and rolling them into larger funds that hold bonds from across the country. More than three dozen single-state muni funds have been folded into national muni funds since last year, with many more potential mergers on the way, says Jeff Tjornehoj, a senior research analyst at Lipper. Mergers like this usually require a shareholder vote, but many investors don t read proxy materials, experts say. Worse, the move could give investors a higher tax bill. States give investors a pass on income they make from most in-state bonds, but income from out-of-state bonds is taxable. If your initial strategy was to eliminate taxes, then the fund company has just negated that strategy, says Craig Ferrantino, a financial planner in Melville, N.Y.

The reason, according to industry experts, is simple: money. Investors, fretful of state budget shortfalls, are pulling money out of funds exposed to one state. Since smaller funds are more expensive to run, Tjornehoj says, the fund company merges the state fund with a larger national fund. Fund firms say the national muni bond funds are more diversified and cheaper to own. Mutual fund firm Federated Investors recently folded its California and North Carolina muni bond funds into a national muni bond fund. A company spokesperson says shareholders in those two states are now paying 30 to 40 percent less in fees than they were before. But planners worry that those savings could be more than wiped out by taxes, because California and North Carolina are going to want a piece of any income their residents earn from, say, an Iowa sewer bond.

For individuals whose biggest concern is taxes, there are still plenty of large single-state municipal bond funds available, planners say. An investor could also just skip the fund altogether and buy a couple of municipal bonds outright, although he or she might be stuck holding the bond until maturity if interest rates rise (generally, bond prices fall when interest rates rise).

Where Did My Muni Fund Go?

Dreyfus rolled three state funds into a national fund that pursues similar investment goals, a spokesperson says.

Eaton Vance folded three state funds into a national one. The bigger fund is cheaper to own, says Christopher Remington, the firm s director of fixed-income product management.

Seligman Investments pooled 14 single-state municipal bond funds into a national fund, giving fund managers greater flexibility, a spokesperson says.