What are General Tax Differences?
Taxes on bond funds and individual bonds may differ depending on:
- How interest income is received
- How capital gains are realized and distributed
Bond funds declare interest dividends either daily or on a monthly basis. The dividends are distributed monthly. On the other hand, individual bonds are taxed on interest in the year in which it is received by the bond holder.
A capital gain or loss may be conceded on a bond fund if it is sold at a greater or lower value than its cost.
Taxes on Bond Mutual Funds
Income earned on bond funds are also distributed with the interest income and capital gains on their investments to shareholders who are taxed later only on the taxable portion of those distributions. The key factors that influence the amount of taxes payable for distributions from bond mutual funds are:
- The amount and type of interest income produced by individual securities held by the fund
- The amount and type of gains or losses attained at the time of the maturity of individual securities or when the individual securities are sold by the fund
- The duration of time that individual securities are held by the fund prior to disposition
- The tax bracket of the recipient of the distribution
Taxes on Individual Bonds
Interest income on individual bonds is taxable as ordinary income at the federal level. However, income produced by municipal securities is usually exempted income from income tax at the federal level. It may be exempted from tax at the state and local level too if the investor buys certain bonds distributed by the state in which the investor resides.
If an investor sells an individual bond for a gain, the gain attributable to accumulated market discount is normally taxable as ordinary income at both the state as well as federal levels. Any gain beyond the accrued market discount will generally be treated as a capital gain for federal tax purposes.
What are Deferring Taxes?
Possessing taxable bond funds and individual bonds in retirement accounts is one method to defer taxes on the interest income. Any type of earning in a tax-deferred retirement account will keep on growing till it is distributed. If taxable bond funds or individual bonds are held in tax-free account such as a Roth IRA, the income from them would be federal income tax-free, provided it meets certain considerations.
Municipal Bond Funds and Bonds
The interest produced by municipal bonds and the interest dividends distributed by bond funds that invest in municipal bonds are usually free from federal income taxes. They are also usually income tax-exempt at the state level for residents of the issuing state. Capital gains distributed by bond funds and capital gains and losses recognized when bonds or bond fund shares are sold, are however considered taxable.
The Federal Alternative Minimum Tax (AMT) and Bond Income
Interest income is generally free from regular federal income tax. However, it may or may not be free from the federal AMT. Interest dividends distributed by a municipal bond or money market mutual fund may also be subject to the federal AMT if a part of the fund comprises certain ‘private activity’ bonds.