Bond funds are portfolios of bonds available as mutual funds or exchange-traded funds. The dividends provided stem from the interest the fund earns. A tax-exempt bond fund contains tax-free municipal bonds issued by state and local entities. Depending on where you live, some of the bond interest may incur state or city income tax. The capital gains from bond funds are not necessarily tax exempt, but they might qualify for lower tax rates.
Sources of Capital Gains
You can incur capital gains and losses from a bond fund in two ways. The fund generates gains or losses whenever it sells bonds within its portfolio. You also generate capital gains and losses when you sell fund shares. The gains or losses are the proceeds from sales minus the cost basis of the bonds or shares sold. The cost basis is the amount spent to make a purchase, minus any commissions. If you make multiple purchases or reinvest dividends, the cost basis of each purchase can be different. The dates of purchase and sale determine whether your capital gains and losses are short term or long term. Unless you specify what shares to sell, a fund can average all your cost bases together or instead match purchases and sales on a first-in, first-out basis.
Early in the new year, your bond fund will send forms to you and the Internal Revenue Service detailing your capital gains and losses for the previous year. IRS Form 1099-DIV lists both the interest-based dividends and the capital gains distributions you earned from the bond fund. Form 1099-B reports your sales of fund shares. Both forms indicate whether the gains and losses were short term, arising from the sale of positions held for a year or less, or long term, arising from the sale of positions held longer than a year. Use the information to complete Form 8949 and Schedule D of Form 1040 when you file your tax return.
The IRS taxes short-term capital gains at your marginal tax rate. However, you receive a tax break on long-term capital gains. For 2013, your tax rate is 20 percent if your modified adjusted gross income, or MAGI, is more than $400,000. The threshold is $450,000 for married couples filing jointly. If your MAGI is less than these amounts, your tax rate is 15 percent when your tax bracket is 25 percent or higher. Otherwise, your capital gains are tax free. Capital losses offset capital gains and up to $3,000 of ordinary income. You can roll unused capital losses forward and apply them in future years.
Individuals with MAGI greater than $200,000 and married couples with MAGI in excess of $250,000 are subject to a Medicare surcharge that went into effect in 2013. The amount of the tax is 3.8 percent of your investment income or the amount by which your MAGI exceeds the noted thresholds, whichever is smaller. Investment income stems from items such as capital gains, interest, dividends, rents and royalties. In this context, investment income does not include withdrawals from qualified plans such as individual retirement accounts. However, such withdrawals are part of MAGI.
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