You need to set both the input encoding and the font encoding to Latin1.
I have a Latex2e file which starts as follows:
\documentclass[a4paper,german]{article}
% allow extended characters in fonts
% -- needed for automatic hyphenation for words with extended characters
\usepackage[T1]{fontenc}
% allow extended characters in input
\usepackage[latin1]{inputenc}
% multilingual support
\usepackage{babel}
It does automatically hyphenate words containing umlauts; but only if the font
encoding is set to T1. You need the ed-fonts for that (part of a recent teTeX
distribution)
All the best, Horst Kausch
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