Nontaxable Dividends

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Nontaxable Dividends

DEFINITION of Nontaxable Dividends

Nontaxable dividends are tax-free dividends paid by a mutual fund or another regulated investment organization. Because they invest in municipal or other tax-exempt assets, these funds are often not taxed.

BREAKING DOWN Nontaxable Dividends

A mutual fund is an investment instrument that consists of a collection of money from several investors. Mutual funds invest in a wide range of securities, including stocks, bonds, money market instruments, and other assets. Mutual fund shares provide investors with two forms of earnings: dividends and interest on assets maintained in the fund portfolio, or investment income; and capital gains from the for-profit selling of portfolio securities.

Investment income may be reinvested in the fund or distributed to the investor in cash. It is taxed as regular income in either case, depending on the investor’s marginal tax level.

Nontaxable Dividends

However, not all dividends are liable to taxes. Interest received on municipal bonds, which are bonds issued by states and towns to obtain funding for general operations or a particular project, is one popular source of tax-exempt income. When a taxpayer earns interest on municipal bonds issued in their home state, the benefit is tax-free on both the federal and state levels.

To be regarded as nontaxable, a mutual fund’s capital must be largely invested in tax-exempt assets.

Municipal Bonds

Municipal bonds (abbreviated “munis”) are debt instruments issued by states, cities, counties, and other government bodies to support day-to-day commitments and capital projects such as the construction of schools, roadways, and sewage systems. When you buy municipal bonds, you are effectively lending money to the bond issuer in exchange for the promise of regular interest payments, generally semi-annually, and the return of your initial investment, or “principal.” The maturity date of a municipal bond (the day when the bond’s issuer repays the principal) might be years in the future. Short-term bonds mature in one to three years, whereas long-term bonds take more than a decade to maturity.

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Municipal bond interest is generally free from federal income tax. If you live in the state where the bond is issued, the interest may also be free from state and local taxes. Bond investors often want a consistent stream of income payments and, as compared to stock investors, may be more risk-averse and concerned with maintaining rather than developing capital. Because of the tax advantages, municipal bonds often have lower interest rates than taxable fixed-income assets such as corporate bonds.

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