Consider Your Tax Status when Choosing a Bond Fund

Investing in a bond fund can provide you with a secure source of income over the long-term. These type of funds have a good track record and represent a very low risk type of investment. However, when you are about to invest in this type of fund, there are several things that you will need to consider. One of the most important things to look at is your tax status. Here are a few things to consider about looking at your tax status when choosing a bond fund.

Types of Bond Funds

There are several bond funds in the market for you to choose from. All of them have different investment strategies and different levels of return. While there are many different strategies to choose from, there are basically two different types of bond fund that you could choose from. One type of bond fund invests in corporate bonds and federal government bonds. This type of bond fund will provide regular interest payments to you that will be taxed. 

The other type of bond fund that you could consider investing in is a municipal bond fund. A municipal bond fund is a bond fund that invests in municipal bonds. Municipal bonds are bond funds that are issued by municipalities such as school systems and local governments. The money that is generated from interest payments on these bonds is not taxable. This means that the money that you receive from the municipal bond fund is tax-free.

Considering Tax Status

Even though investing in a tax-free bond might sound very attractive, it will only be to your advantage if you are in the proper tax bracket. Not everyone will be able to make enough money from this category of bonds to justify investing in them. The reason behind this is that the interest rates paid by municipal bond funds are generally quite a bit lower than what you can get from a regular bond fund. This means that even after paying taxes on regular interest, you might come out ahead when compared to a municipal bond. 

Example

In order to understand this concept, it may help to look at an example dealing with two different bond funds. The first bond fund is a traditional bond fund that invests in corporate bonds. This bond fund provides you with a rate of return of 6 percent. If you invested $1000, you will get $60 in interest. 

The second bond fund is a municipal bond fund. It gives you a return of 4 percent on the year. If you invested $1000, this means that you will get $40 in interest. 

Let's say that you are in the highest tax bracket which means that you will have to pay 35 percent in taxes on the money that you earn. This would mean that you would have to pay $21 in taxes on the traditional bond fund. This would give you a profit of $39 on the year after taxes. This means that even though the municipal bond fund only paid 4 percent, it actually gave you $1 more in profit. 

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