Tax Treatment on a Bond Mutual Fund

In general, your investment in a bond mutual fund is subject to the same tax regulations as with a typical mutual fund, but there are certain exceptions. Major exceptions include tax deferred or tax exempt retirement accounts and Treasury bonds. Mutual funds have complicated tax treatment because of the various types of dividends they can pay out, and each type of dividend is treated in a unique manner come tax time. 

Retirement Accounts

Depending on how you structure your retirement account, your tax treatment will vary. For example, Roth accounts are taxed on the front end, while traditional accounts are taxed on the back end. If your mutual fund account is held within your retirement account, speak with a tax professional about the best options to achieve tax minimization. Generally speaking, Roth IRAs and 401(k)s give tax benefits in the future, while traditional accounts give the tax benefits in the present. There are many advantages to each of these options, however, beyond the simple tax advantages of one over the other.

Treasury Bonds and Exempt Interest Distributions

Treasury bonds grow tax free on both federal and state levels. If you have a mutual fund made up entirely of Treasury bonds, you will not owe taxes on the earnings. Some municipal bonds are also completely exempt. Corporate bonds, though, are not tax exempt in any of their forms. The exemption of your bonds can be complicated if you invest in a bond mutual fund through a retirement account, which already has separate tax deferment options.

Ordinary Dividends

A bond's yield is considered its dividend. Ordinary dividends are taxed at ordinary tax rates based on your income. They are considered part of your annual income, and they are reported in the W-2 document provided by your mutual fund at the end of the tax year. Since you know the yield of your bond when you purchase it, you can budget for these payments as part of your tax planning each year. This is an advantage over a traditional mutual fund.

Capital Gains Distributions and Allocations

When a mutual fund actually adds value, this is considered a capital gain. The gains can be distributed or allocated. Most mutual funds distribute the capital gains. On a traditional mutual fund, capital gains qualify for some preferred tax treatment if they are distributed in the long term. Short-term capital gains are treated as ordinary dividends, though. It is rare for a mutual fund, specifically a bond mutual fund, to use capital allocation. This would actually raise the value of the principal of your bond. If this occurs, however, the taxes would need to be filed as an allocation and not a distribution.

Non-Dividend Distributions

A mutual fund will pay earnings that are not categorized as income distributions. With a bond, this is the repayment of your principal. You do not have to report this as income because it is not actually considered income. However, if you lost or gained principal before repayment, then this will need to be adjusted for in capital gains taxes.

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