1. Money

How are Bond Funds Taxed?

By

Mutual fund taxation can be confusing, particularly for bond investors. Mutual funds are taxed in three different ways: 1) dividend income, 2) capital gains incurred by the fund each year, and 3) the final gain (or loss) you have when you sell.

Taxes on Investment Income

Of the three, this tax is easiest to understand. The interest that bond funds receive from their investments and pay out to shareholders is considered investment income and is taxable at the federal and state level.

There are two important exceptions to this rule. First, interest earned from U.S. Treasuries held in mutual funds may be exempt from state taxes. Second, the interest from municipal bond funds may be non-taxable on the federal level and, if the income is owned by a bond issued by their state of residence, it may be non-taxable on the state level as well. To find out the particulars of an individual fund, read the prospectus or call the issuing fund company to make sure you know exactly what you’re getting.

Capital Gains Incurred Each Calendar Year

Throughout the course of each year, mutual funds will buy and sell securities, sometimes with a gain and sometimes with a loss. If the gains exceed the losses, the result is a capital gain for the fund. This gain is paid out to shareholders in the form of a distribution, typically at year-end but sometimes at other points throughout the year. The fund’s share price is adjusted downward to account for the capital gain distribution. There are two types of capital gains: short-term (for securities held less than a year) and long-term (for those held more than a year).

Consider this example of how the capital gains work. ABC Fund, which has a $10.00 net asset value at the beginning of the year, buys two bonds. Each rises by 10% in price. The fund holds the first bond through the end of the year, but it sells the second. At year-end, the fund’s share price is $11.00 (reflecting the 10% gain of its holdings). However, half of that $1 gain was realized (through the sale of the second bond) and is therefore taxable. The fund pays a .50 cent distribution from the realized gain, and the investor has to pay a capital gains tax (in this case, of the short-term variety). The fund’s share price drops to $10.50 to reflect the 50-cent distribution.

Capital Gains Incurred When the Fund is Sold

Paying the two taxes mentioned above takes care of the investor’s requirements in a particular calendar year. But there’s still the matter of the remaining 50-cent gain in the fund’s value from the example above. This is the gain that remains imbedded in the fund’s share price, and that the investor will need to pay upon the sale of the fund.

For the sake of simplicity, let’s say ABC Fund makes no further trades but the two outlined in the previous section. The investor sells the fund in February of the year following his or her initial purchase for $10.50 a share. Since the investor initially paid $10.00, the remaining 50 cents is also taxable as a capital gain (in this case, a long-term capital gain since the fund was held for more than a year).

Conclusion

The easiest way to think about this subject is that any time you make money in a mutual fund, you will have to pay a tax. It may be at the end of the calendar year, or it may be when you finally sell the fund, but Uncle Sam will take his cut eventually.

This doesn’t mean you can’t work to minimize your taxes, however. To learn ways to reduce your tax bill, see How to Reduce Taxes on Mutual Funds: 10 Ways to Lower Your Tax Bill.

Disclaimer: Always consult a tax professional before making investment decisions.

©2014 About.com. All rights reserved.