Taxes on Bonds and Bond Funds - Fidelity (2024)

Bonds and bond funds are taxed in 2 ways—based on the income that's distributed and on any gains if the investment is sold at a profit. Because individual bonds and bond funds distribute income differently and treat your principal differently, there are also some differences in how that income and any capital gains are taxed.

Taxes on individual bonds

Tax on income

The tax implications of individual bonds are fairly straightforward: If an investor owns bonds that generate taxable income (which covers almost all bonds except for municipal bonds, in general), he or she is taxed on that income in the year it's received.

Interest income generated by municipal bonds is generally not subject to federal taxes, and may be tax-exempt at the state and local level as well, if the bonds were issued by the state in which you live. To learn more about municipal bond and tax-free investing, please visit our Fixed Income Research Center. As always, you should consult a tax professional for more help.

Tax on capital gains

A capital gain is tax terminology for a profit. If you bought the bond when it was issued at its original issue price and hold it until maturity, you generally will not recognize a capital gain (or loss). As a result, you likely won't incur any capital gains tax.

If, however, you purchase a municipal bond in the secondary market at a discount to the revised issue price, you can be taxed as either a capital gain or ordinary income, depending on the size of the discount and the years to maturity of the bond.

Taxes on bond funds

Mutual funds that invest in bonds typically provide regular income from a portfolio of many securities. As a result, the tax on the income is dependent on the types of securities held by the fund. What’s more, since fund managers regularly buy and sell bonds, there may also be capital gains and losses incurred. Bond funds pass along the interest income and capital gains on their investments to shareholders, who are then taxed on the taxable portion of those distributions. While you will want to consider a fund’s total return when evaluating it as an investment, keep in mind that the stated historical return of a fund is usually expressed as a pretax number.

Tax on income

The interest generated by bond funds is typically calculated daily, but paid out to investors monthly. How that income is taxed depends on the underlying investments that are generating that income. The income from taxable bond funds is generally taxed at the federal and state level at ordinary income tax rates in the year it was earned. Funds that exclusively hold U.S. Treasury bonds may be exempt from state taxes. Interest income generated by municipal bond funds is generally not subject to federal taxes, and may also be exempt from state and local taxes if the bonds held by the fund were issued by the state in which you live. Before buying a fund, read its prospectus to determine whether interest from the fund is expected to be subject to federal, state, or local taxes.

Tax on capital gains

There are 2 ways investors could owe capital gains tax on a bond fund investment. First, there are the capital gains (and losses) generated by the fund manager, as he or she buys and sells securities. Whether the profit from the sale of a bond in the fund is taxed at ordinary income tax rates or is eligible for a reduced capital gains rate is dependent on the same factors as explained above. These gains or losses are generally distributed to investors once or twice a year. The fund company will account for how your total gain or loss is generated and will tell you which portion is attributable to long-term capital gains, short-term capital gains, and interest income—all of which will affect the amount of tax you owe.

Secondly, when you sell shares of the fund itself, you'll incur a gain or a loss depending on your cost basis, the amount of your initial investment, and any reinvested dividends. Any capital gains are taxable, and any capital losses may generate a tax benefit.

You may want to consult with your tax advisor to find out how the specifics of your individual tax situation may affect the tax treatment of income generated by your investments.

Deferring taxes

Like other investments, the tax owed on bonds and bond funds can be deferred by holding them in a tax-advantaged retirement account, such as a 401(k) or IRA. With that strategy, you won’t owe any tax until you withdraw money at retirement, at which point you'll owe ordinary income tax on any distribution.

If taxable bond funds or individual bonds are held in a tax-free account such as a Roth IRA, then the income from them would be free from federal taxes, provided certain requirements are met.

Taxes on Bonds and Bond Funds - Fidelity (2024)

FAQs

Do I pay taxes on bond funds? ›

The tax rate charged will depend on how long you held the bond. If you've held it for less than a year, you'll be charged at your regular income tax rate. Bonds held for more than a year will be subject to potentially lower long-term capital gains rates.

Does Fidelity have a tax-exempt bond fund? ›

FCSTX - Fidelity ® California Limited Term Tax-Free Bond Fund | Fidelity Investments.

Should I hold bond funds in a taxable account? ›

Certain bond holdings can be a particularly bad idea for taxable accounts. High-yield bond funds, because they tend to generate (relatively) large amounts of current income, are best avoided in taxable accounts.

How much tax do you pay on savings bonds? ›

Savings bond interest is exempt from state and local income tax. Savings bond interest is subject to federal income tax; however, taxation can be deferred until redemption, final maturity, or other taxable disposition, whichever occurs first.

How to avoid paying taxes on savings bonds? ›

You can skip paying taxes on interest earned with Series EE and Series I savings bonds if you're using the money to pay for qualified higher education costs. That includes expenses you pay for yourself, your spouse or a qualified dependent. Only certain qualified higher education costs are covered, including: Tuition.

How do you pay taxes on bonds? ›

You choose when you report the interest on I bonds, which is another advantage. Most people report the interest on their federal income tax return the year they give up ownership of the bond and receive what the bond is worth, including the interest. But others may find it advantageous to report the interest each year.

Does Fidelity allow you to buy bonds? ›

Fidelity offers investors the opportunity to participate in both the new issue and secondary bond markets. Investors pay no commissions or concessions when participating in new issue offerings, but Fidelity charges a mark-up (for buys) or mark-down (for sells) in the secondary market.

Does Fidelity have a tax-free money market? ›

FMOXX - Fidelity ® Tax-Exempt Money Market Fund | Fidelity Investments.

Can you do bonds on Fidelity? ›

In this video you'll learn how to navigate the Fixed Income, Bonds & CDs page on Fidelity.com to search for Bonds and CDs to build your fixed income portfolio, view bond-related news and research, access bond tools, and learn about services to help manage your portfolio.

What is the downside of bond funds? ›

The disadvantages of bond funds include higher management fees, the uncertainty created with tax bills, and exposure to interest rate changes.

Is it better to hold individual bonds or bond funds? ›

By Lacey Cobb, CFA, CFP® For many investors, investing in the right bond funds can be a better option than holding a portfolio of individual bonds. Bond ETFs can provide better diversification — often for a lower cost — can offer higher liquidity, and can be easier to implement.

What are the cons of bond funds? ›

The downside to owning bond funds is: The management fee: Management fees for the more actively traded bond funds can be higher, which may lead to lower returns.

Do I need to report I bonds on my tax return? ›

In general, you must report the interest in income in the taxable year in which you redeemed the bonds to the extent you did not include the interest in income in a prior taxable year.

How much is a $100 savings bond worth after 30 years? ›

How to get the most value from your savings bonds
Face ValuePurchase Amount30-Year Value (Purchased May 1990)
$50 Bond$100$207.36
$100 Bond$200$414.72
$500 Bond$400$1,036.80
$1,000 Bond$800$2,073.60

What bonds are tax free? ›

Municipal Bonds

Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes.

What bonds are federal tax free? ›

Municipal Bonds

Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes.

How are tax free bond funds taxed? ›

Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income.

Are there any tax-free investments? ›

Roth IRAs. A Roth IRA is an individual retirement account that allows you to invest after-tax dollars so you can make tax-free withdrawals in retirement. Unlike a Roth 401(k), you don't need an employer sponsorship to participate in a Roth IRA.

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