Bond Mutual Fund Taxes
To understand why it makes sense to hold your bond mutual funds in a qualified plan you first need to understand how taxes on investments work.
The two main types of taxes most investors pay on their investments are capital gains taxes (or capital loss deductions) and taxes on interest and dividends. Capital gains taxes must be paid whenever an investment is sold for a profit. For example, if an investor buys an investment position for $25,000 and then later sells it for $40,000, there is a $15,000 profit, or capital gain.
There are two kinds of capital gains taxes. Short-term capital gains are typically due for any investment held for less than one year. Investments held for longer than one year are subject to more favoralbe long-term capital gain tax rates. For most tax payers, the tax rate for long-term capital gains is 15 percent.
The important thing to understand about capital gains is that they only occur when you sell securities. No capital gains taxes are due while you still own the investment. If you own shares of IBM stock for 20 years, you don't owe any taxes on them until you sell shares, regardless of how high the share price goes.
Taxes on dividends and interest payments, by contrast, are due each year when they are paid. In other words, if you earn $1,000 of interest, you owe taxes on that $1,000 interest payment, regardless of what you do with the $1,000. You owe taxes on the $1,000 even if you reinvest the interest payment in your bond mutual fund.
Unlike capital gains taxes, and taxes on dividends, there is no special tax rate for interest payments. Ineterest is taxed at your ordinary income tax rate. If you are in the 30 percent tax bracket, the taxes on interest you earn is 30 percent.