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| General Tax Differences |
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| From a tax standpoint, the main differences between bond funds and individual bonds is: How interest income is received and how capital gains are realized and/or distributed. |
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Bond funds typically declare interest dividends daily or monthly and distribute those dividends monthly. Distributions of taxable interest earned are generally taxed in the year in which they accrue. Fund distributions attributable to capital gains are generally paid once or twice per year. |
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Holders of individual bonds are taxed on interest, if taxable, earned in the year it was received. |
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| A capital gain or loss may be recognized on a bond fund if it is sold at a price greater or less than its cost basis. |
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| A holder of a bond purchased at the original issue price generally will not recognize a capital gain or loss if the bond is held to maturity. Bonds purchased in the secondary market at a premium or discount may, depending on tax elections made by the holder, give rise to a taxable gain or loss at maturity. A bond sold by a holder prior to maturity will normally result in a capital gain or loss for tax purposes. |
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| Investors who purchase individual bonds at a discount or a premium generally need to amortize or accrete the premium or discount amount each year until they dispose of the bond. The cost basis of the bond is adjusted for these annual amortization and accretion amounts. Consult a tax professional for more details on the different amortization and accretion methods and how they may affect your cost basis. |
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| Taxes on Bond Mutual Funds |
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| 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 pre-tax number. |
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| There are certain key elements that affect the amount of taxes paid on distributions from bond mutual funds: |
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The amount and type of interest income generated by individual securities held by the fund (e.g., municipal bonds, U.S. Treasury securities) |
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The amount and type of gains and/or losses realized when individual securities mature or are sold by the fund |
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The length of time that individual securities are held by the fund prior to disposition |
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The tax bracket of the recipient of the distribution |
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| This hypothetical example compares $10,000 invested in a bond fund paying interest dividends exempt from federal income taxes and a bond fund paying interest dividends taxable at the federal level. In the example, investors in the 28% or 33% federal income tax bracket would have ended up with more after-tax interest income from the municipal bond fund even though its yield was lower. |
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| Subject to certain exceptions, such as those applicable to municipal bond mutual funds, the interest income distributions from bond funds are generally taxable as ordinary income at the federal level. Many states also impose state income taxes on distributions. |
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| Interest income generated by municipal bond funds holding bonds issued by the shareholder's state of residence may be free from both federal and state income taxes, but capital gains distributed by the fund or recognized when the fund is sold are generally taxable. The interest income from mutual funds holding 100% U.S. Treasury securities may be exempt from state taxes. Be sure to read each fund's prospectus before purchase to determine whether interest from the fund is expected to be subject to federal, state, or local taxes. |
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| When a fund manager sells a bond in the mutual fund at a profit,* the gain attributable to accrued market discount is generally distributed as an ordinary dividend taxable as ordinary income at both the state and federal level. Any gain at the fund level in excess of accrued market discount will generally be treated as a capital gain by the fund. The net long- and/or short-term gain is then distributed to the mutual fund shareholder. Regardless of whether the fund holds U.S. Treasury securities or municipal securities, all capital gains distributions are generally taxable. Conversely, if the fund manager sells a security at a loss, that loss may be used to offset current or future capital gains realized by the fund. |
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| How much you pay in taxes on capital gains distributions depends on how long the fund held the securities before it sold them and your individual income tax bracket. |
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Net capital gains recognized on securities held by the fund one year or less are distributed as short-term capital gains. These gains are taxed at the federal level at your marginal ordinary income tax rate |
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Net capital gains recognized on securities held by the fund more than one year are distributed as long-term capital gains. These gains are taxed as long-term capital gains at the federal level, at rates not in excess of 15%. |
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| If you sell shares of a mutual fund, any capital gains are taxable, and any capital losses may generate a tax benefit. |
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| You may want to consult your tax advisor to find out how the specifics of your individual tax situation may affect the tax treatment of income generated by and on your investments. |
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| Taxes on Individual Bonds |
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| Subject to certain exceptions, interest income generated by individual bonds is taxable as ordinary income at the federal level. Interest income generated by municipal securities is generally income tax-exempt at the federal level and may be income tax-exempt at the state and local level too if the investor purchases certain bonds issued by the state in which the investor resides. |
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| If an investor sells an individual bond for a gain,** the gain attributable to accrued market discount is generally taxable as ordinary income at both the state and federal level. Any gain in excess of accrued market discount will generally be treated as a capital gain for federal income tax purposes. Short-term capital gains are taxed as ordinary income. Net capital gains from bonds held for more than one year are long-term capital gains taxable at federal rates not in excess of 15%. Conversely, if the bond is sold for a loss, the loss is treated as a long- or short-term capital loss. Capital losses can generally be used to offset capital gains. Net capital losses can usually be used by individual taxpayers to offset up to $3,000 (or $1,500 if married filing separately) of ordinary income. |
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| You may want to consult your tax advisor to determine how the tax treatment of income or capital gains or losses may impact your individual situation. |
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| Deferring Taxes |
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| Holding taxable bond funds and individual bonds in retirement accounts is one way to defer taxes on the interest income. Any type of earning in a tax-deferred retirement account will continue to grow tax-deferred until distributed, at which time your tax bracket may be lower than it is now. |
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| If taxable bond funds or individual bonds are held in tax-free account such as a Roth IRA, then the income from them would be federal income tax-free provided certain requirements are met. |
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| Municipal Bond Funds and Bonds*** |
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| Municipal bond funds usually invest primarily in municipal bonds. The interest generated by municipal bonds and the interest dividends distributed by bond funds that invest in municipal bonds is usually exempt from federal income taxes and is usually income tax-exempt at the state level for residents of the issuing state (of the underlying bond investment in the case of a bond fund). Capital gains distributed by bond funds and capital gains and losses recognized when bonds or bond fund shares are sold are still taxable, however. |
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| Although municipal bonds and bond funds generally have a lower stated yield that is lower than the pre-tax yield of a comparable taxable bond or bond fund, you may actually earn more after taxes by investing in lower-yield, tax-free investments than you would by investing in higher-yield taxable investments. |
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Investors in higher federal ordinary income tax brackets (25% or greater) may find that a municipal bond fund or bond investment with a lower stated yield actually generates more after-tax interest income than a similar taxable investment. |
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Customers in lower tax brackets will often receive more interest income after taxes from taxable securities. The tax benefit of investing in municipal or tax-exempt securities is usually smaller than the tax benefit received by investors in higher tax brackets. |
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Keep in mind that it is usually inappropriate to purchase tax-free, municipal investments in tax-advantaged accounts. |
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| *** Municipal bond funds normally seek to earn income and pay dividends that are expected to be exempt from federal income tax. If a fund investor is resident in the state of issuance of the bonds held by the fund, interest dividends may also be free of state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes. Fund shareholders may also receive taxable distributions attributable to a fund's sale of municipal bonds. Fund redemptions, including exchanges, may result in a capital gain or loss for federal and/or state income tax purposes. Interest income generated by municipal bonds is generally expected to be free from federal income taxes and, if the bonds are held by an investor resident in the state of issuance, state and local income taxes. Such interest income may be subject to federal and/or state alternative minimum taxes. Short- and long-term capital gains and gains characterized as market discount recognized when bonds are sold or mature are generally taxable at both the state and federal level. Short- and long-term losses recognized when bonds are sold or mature may generally offset capital gains and/or ordinary income at both the state and federal level. Investing in municipal bonds or municipal bond funds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. |
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| The Federal Alternative Minimum Tax (AMT) and Bond Income |
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| Interest income that is generally exempt from regular federal income tax, such as the interest on state and local municipal bonds, may or may not be exempt from the federal AMT. If certain bonds were issued to pay for such "private activities" as housing projects, hospitals, or certain industrial parks, the interest income may be includable as income when calculating 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 portion of the fund consists of certain "private activity" bonds. The fund's prospectus will tell you if it seeks to generate only interest dividend income exempt from the federal AMT. |
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| More and more taxpayers are subject to the AMT. To find out if you might be one of them, visit Alternative Minimum Tax (AMT): What Is It and Why Should You Care? |
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| For investments to help manage your AMT exposure, Fidelity offers AMT-free municipal bond and money market funds that are managed with the intent of normally investing only in securities paying interest income exempt from both federal income taxes and the federal AMT. |
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