Investing Assets & Markets Bonds Bond Funds Taxation and Capital Gains By Thomas Kenny Thomas Kenny Thomas Kenny is an expert on investing, including bonds, ETFs, and mutual funds. He has more than 25 years of experience in the finance industry and is a partner and co-founder at Boston Investor Communications Group, a communications company for mutual fund and other investment industry providers. learn about our editorial policies Updated on February 20, 2022 Reviewed by Thomas J. Brock Reviewed by Thomas J. Brock Thomas J. Brock is a CFA and CPA with more than 20 years of experience in various areas including investing, insurance portfolio management, finance and accounting, personal investment and financial planning advice, and development of educational materials about life insurance and annuities. learn about our financial review board Fact checked by Vikki Velasquez Fact checked by Vikki Velasquez Vikki Velasquez is a freelance copyeditor and researcher with a degree in Gender Studies. Previously, she conducted in-depth research on social and economic issues such as housing, education, wealth inequality, and the historical legacy of Richmond VA as well as their intersectionality while working for a community leadership nonprofit. Vikki leverages her nonprofit experience to enhance the quality and accuracy of Dotdash's content. learn about our editorial policies Share Tweet Pin Email In This Article View All In This Article 1. Taxes on Investment Income 2. Capital Gains Incurred Each Calendar Year 3. Capital Gains When the Fund Is Sold The Bottom Line Photo: Maskot / Getty Images Mutual fund taxes can be confusing. This is particularly true for bond investors. The confusion comes because mutual funds are taxed in three different ways. First, they may be taxed as dividend income; second, they could be taxed as capital gains incurred by the fund each year. Finally, they may be taxed by appreciation at the time of sale. Learn more about the three types of taxes on mutual funds. Key Takeaways Bond funds receive interest, and your portion of this is considered investment income. It is taxed and the federal and state level.Interest from U.S. Treasury bonds may be exempt from state taxes, and interest from municipal bond funds may be exempt from federal and state taxes.Yearly fund gains are distributed to shareholders and subject to capital gains tax, either short-term or long-term.When you sell shares in a fund, you will have to pay capital gains tax on any appreciation in the value of your shares. 1. Taxes on Investment Income Of the three, this tax is easiest to understand. The interest that bond funds receive from their investments and payout to shareholders is considered investment income and is taxable at the federal and state level. There are two important exceptions to this rule. First, interest earned from the U.S. Treasury held in mutual funds may be exempt from state taxes. Second, the interest from municipal bond funds may be non-taxable on the federal level and, if the income is owned by a bond issued by their state of residence, it may be non-taxable on the state level as well. To find out the particulars of an individual fund, read the prospectus or call the issuing fund company to make sure you know exactly what you’re getting. 2. Capital Gains Incurred Each Calendar Year Throughout the course of each year, mutual funds will buy and sell securities, sometimes with a profit and sometimes with a loss. If the gains exceed the losses, the result is a capital gain for the fund. This gain is paid out to shareholders in the form of distribution, typically at year-end but sometimes at other points throughout the year. The fund’s share price is adjusted downward to account for the capital gain distribution. There are two types of capital gains: short-term (for securities held less than a year) and long-term (for those held more than a year). Consider this example of how capital gains work. ABC Fund, which has a $10.00 net asset value at the beginning of the year, buys two bonds. Each rises by 10% in price. The fund holds the first bond through the end of the year, but it sells the second. At year-end, the fund’s share price is $11.00 (reflecting the 10% gain of its holdings). However, half of that $1 gain was realized (through the sale of the second bond) and is, therefore, taxable. The fund pays a .50 cent distribution from the realized gain, and the investor has to pay a capital gains tax (in this case, of the short-term variety). The fund’s share price drops to $10.50 to reflect the 50-cent distribution. 3. Capital Gains Incurred When the Fund Is Sold Paying the two taxes mentioned above takes care of the investor’s requirements in a particular calendar year. But there’s still the matter of the remaining 50-cent gain in the fund’s value from the example above. It is the gain that remains embedded in the fund’s share price, and that the investor will need to pay upon the sale of the fund. For the sake of simplicity, let’s say ABC Fund makes no further trades but the two outlined in the previous section. The investor sells the fund in February of the year following their initial purchase for $10.50 a share. Since the investor initially paid $10.00, the remaining 50 cents is also taxable as a capital gain (in this case, a long-term capital gain since the fund was held for more than a year). The Bottom Line The easiest way to think about this subject is that any time you make money in a mutual fund, you will have to pay a tax. It may be at the end of the calendar year, or it may be when you finally sell the fund, but Uncle Sam will take his cut eventually. It doesn’t mean you can’t work to minimize your taxes, however. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Internal Revenue Service. "Publication 550 (2020), Investment Income and Expenses."