Taxes on Bonds and Bond Funds

A reader writes in with a question about taxes on bond funds:

“When I own a Treasury bond fund, I’m guessing I would be paying taxes on the interest through the term of the bond. When I sell, would there be additional tax consequences?

I get that other types of investments — stocks for example — have price changes that affect the tax consequences when I sell. But a Treasury bond would only have interest, right? No gains/losses, because it pays at a fixed rate?”

Before discussing how a bond mutual fund is taxed, it’s probably easier to back up a step and discuss the tax treatment of an individual bond.

If you buy a bond for when it’s originally issued, and you hold the bond until it matures, yes, you would only have to pay taxes on the interest along the way.

However, if you buy a bond and sell it prior to its maturity date, you would probably have either a capital gain or a capital loss, because the sale price would almost certainly be either higher or lower than what you paid for it. (Because, as we’ve discussed here before, bond prices move up and down in the opposite direction of market interest rates.)

If the bond is sold for a capital gain, it would work the same as selling a stock for a capital gain. That is, if you had held the bond for one year or less, it would be a short-term capital gain, taxed at your ordinary income tax rate. If you had held the bond for greater than one year, it would be a long-term capital gain, taxed at a maximum rate of 15%.

Taxes on Bond Funds

Owning a bond mutual fund works a bit differently. Each year, shareholders of mutual funds are responsible for paying taxes on:

1. Their share of the interest and dividends earned by the fund’s holdings, and
2. Their share of any net capital gains realized within the fund’s portfolio (that is, gains that occur when the fund sells investments within its portfolio for an amount greater than what it paid for them).

In other words, with mutual funds (including bond funds), you often have to pay capital gains taxes even while you still hold the fund.

Finally, when you do sell the fund, there will typically be a capital gain or loss on that transaction, calculated just like you’d expect: proceeds from the sale, minus your cost basis in the mutual fund shares that you sold.

Important note: Your cost basis includes not only the amount you paid for the initial fund shares you purchased, but also any dividend/gain distributions that you chose to reinvest in order to purchase additional shares.