Tax law lacks loophole for bond funds

Q. In your recent column about the new tax cuts, I was surprised you did not mention that you can get around paying the high tax rate on bond interest by investing through bond "funds." Income from funds comes through dividends, which are subjected to the lower capital-gain rate.
A. If only it were true, I'd gladly run a correction.
Unfortunately, the lawmakers who wrote the new rules made sure they didn't leave this loophole. Since quite a few readers sent me messages on this issue, let's clear it up.
Mutual funds that own bonds do indeed pay "dividends" to shareholders. Since the tax law passed late last month reduced the federal tax on dividends to a maximum of 15 percent, compared with a maximum 38.6 percent under the old rules, this would seem to be good news.
But it doesn't work that way. The dividends from bond funds come from interest payments the fund received from the bonds it owns. Interest is taxed as income, at rates ranging from 25 percent to 35 percent for most investors under the new law. (The maximum was 38.6 percent under the old rules.)
Interest, by any other name, is still interest. So the bond-fund "dividends" you receive will be taxed like interest -- at income-tax rates.
Cutting 'double taxation'
The idea behind the dividend rate cut was to reduce the "double taxation" that had been levied against dividends. That happens because dividends come from a corporation's profit, on which it already has paid income tax. Then the shareholders pay again when they receive the dividends.
President Bush wanted to eliminate the tax paid by shareholders, but he had to settle for a reduction instead.
Interest is not treated the same as dividends because it has not been subject to double taxation.
A company that sells bonds to investors is, in fact, borrowing from those bond buyers. After a given term, the bond will mature and the company will pay back the money it borrowed -- the principal.
In the meantime, it pays the bond owners interest on the loan. Since the interest payment is a business expense, the company can deduct it on its federal tax return. In other words, the company is not taxed on the interest payment, it's getting a tax break.
A bond fund merely passes on to investors the interest earned on the individual bonds in the fund. The only break the bond investor will get is the small cut in income-tax rates in the new law -- 2 percentage points in most brackets.
Another consideration
There is, however, another wrinkle. The fund is constantly buying and selling bonds before they mature. As prevailing interest rates move up and down, some bonds are sold at a profit, others at a loss. If rates fell from 6 percent to 4 percent, for example, traders would be willing to pay more for the older 6 percent bonds, and the fund might make a profit when it sold them. The opposite happens when prevailing rates rise -- older low-rate bonds become less valuable than new high-rate bonds.
If there is a net profit on all these sales at the end of the year, it is passed on to the fund's shareholders in a "capital-gains distribution."
This, too, is taxed, unless the fund is owned in a tax-deferred account such as a 401(k) or an IRA. But different portions of the distribution may be taxed at different rates.
Net profits on bonds the fund had owned for a year or less are taxed at the short-term capital-gains rate. That rate is the same as the income-tax rate -- 25 percent to 35 percent for most investors.
Net profits on bonds that had been in the fund for longer than a year are taxed at the long-term capital gains rate -- 15 percent for most investors.
What it all means
To sum up, there may be three different taxes applied to your bond-fund earnings: income tax and short- and long-term capital-gains tax.
Complicated enough? It can get worse.
Suppose you own a fund that contains stocks as well as bonds.
The bond portion will be subject to the taxes I've described.
In addition, any dividends paid by the stocks will be subject to the new maximum dividend tax rate of 15 percent. Profits on stocks sold by the fund during the year will be subject to the same long- and short-term capital-gains taxes that apply to bonds.
It sounds like an accounting nightmare, but the amounts subject to each type of tax will be detailed in the Form 1099 your fund company will send in January.
There are some things to think about now, though, especially if you are planning to put more money into funds.
If the fund is likely to pay you a lot of money subject to the high income-tax rates levied on interest and short-term capital gains, consider buying that fund through a tax-deferred account. Ultimately, your withdrawals from the deferred account will be subject to those high income-tax rates. But by using the deferred account, you can postpone the payment of those taxes until after you withdraw the money.
Funds that pay dividends and long-term capital gains will do better in ordinary taxable accounts, where the gains and income will be taxed at no more than 15 percent. Buy the same fund in a deferred account and the gains and dividends will be taxed at the higher income-tax rates that apply to all withdrawals from deferred accounts.
XJeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at brownjphillynews.com.