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Bonds can be taxable or tax-free — here's your guide to the different types and calculating what's due on them

Aug 9, 2022, 21:26 IST
Business Insider
Bonds are divided into two classes: taxable and tax-exempt. While their capital gains are always taxable, the interest they earn may not be.baona/Getty Images
  • Bonds and bond funds generate two types of income: interest and capital gains.
  • Interest income from a bond may be taxable or tax-exempt, depending on the type of bond.
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Like most investments, a bond can earn investors money in two ways: through fixed interest payments when an investor holds onto it over a period of time — or by selling it at a higher price than when they first bought it. Unfortunately, like most investments, bonds are also subject to capital gains taxes.

How bonds are taxed

Bonds generate two different types of income: interest and capital gains.

Interest

Bonds are a type of debt security. When you buy a bond, you're loaning money to the government or company that issued it. That entity can leverage that money to bolster returns and pays you back in the form of periodic interest payments and a return of principal once the bond matures. Most bonds pay a fixed, predetermined rate of interest over their lifespan usually in semiannual or annual intervals.

That interest income may be taxable or tax-free (more on the types of bonds that generate tax-free income later). For the most part, if the interest is taxable, you pay income taxes on that interest in the year it's received.

The rate you'll pay on bond interest is the same rate you pay on your ordinary income, such as wages or income from self-employment. If, for example, you're in the 37% tax bracket, you'll pay a 37% federal income tax rate on your bond interest.

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Here's an overview of the 2022 and 2021 tax brackets.

Capital gains

If you buy a bond when it's first issued and hold it until maturity — the full length of its lifespan — you generally won't recognize a capital gain or loss. The money you get back is considered a return of your principal — what you originally invested in it.

However, after they're issued, bonds often trade on financial exchanges, just like stocks. If you sell them before their maturity date on the secondary market, the bonds can generate capital gains and losses, depending on how its current price compares to your original cost. Bond funds can also generate capital gains and losses as the fund manager buys and sells securities within the fund.

So, the profit you make from selling a bond is considered a capital gain. Capital gains are taxed at different rates depending on whether they're short-term or long-term.

Short-term capital gains apply if you hold the bond for one year (365 days) or less. Then the gain is taxed at your ordinary income tax rates.

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Long-term capital gains apply if you hold the bond for more than one year. Then you can benefit from reduced tax rates, ranging from 0% to 20%, depending on your filing status and total taxable income for the year.

Note: The IRS lets single filers and married couples filing jointly to deduct up to $3,000 in realized investment losses from their income tax annually. Leftover losses can be rolled to next year or be deducted from capital gains.

Are all bonds taxed?

Bonds are divided into two classes: taxable and tax-exempt. A bond's tax-exempt status applies only to the bond's interest income. Any capital gains generated from selling a bond or bond fund before its maturity date is taxable, regardless of the type of bond.

Taxable bonds

The interest income from taxable bonds is subject to federal, state (and local, if applicable) income taxes. Though interest on these bonds is taxable, they often offer higher returns — albeit at a higher risk.

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Taxable bonds include:

  • Corporate bonds
  • Mortgage-backed securities
  • Global bond funds
  • Diversified bond funds

Note: Savings bonds and treasury bonds are subject to federal income tax. However, they are generally free from state and local income taxes.

Are municipal bonds tax-free?

Municipal bonds, also known as munis, are the main type of tax-exempt bonds. Munis are issued by states, counties, cities, and other government agencies to fund major capital projects, such as building schools, hospitals, highways, and other public buildings.Any interest income from muni bonds is generally not subject to federal income tax. It can also be exempt from state or local income taxes if your home state or city issues the bond. Interest income from muni bonds issued by another state or city is taxable on your state or local income tax return.

Note: Muni bonds exempt from federal, state, and local taxes are known as "triple tax exempt."

Zero-coupon bonds

Zero-coupon bonds are a special case. You might have to pay tax on their interest income — even though you don't actually receive any interest.

With a zero-coupon bond, you buy the bond at a discount from its face value, don't receive interest payments during the bond's term, and are paid the bond's face amount when it matures.

For example, you might pay $3,000 to buy a 20-year zero-coupon bond with a face value of $10,000. After 20 years, the issuer pays you $10,000. The difference between the amount you pay for a zero-coupon bond and the face amount you receive later is considered "imputed interest."

That interest may be taxable or tax-exempt, depending on whether the bond was issued by the US Treasury (the most common type), a corporation, or a state or local government agency.

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If the interest is taxable, the IRS treats the prorated imputed interest as if it were paid annually, even though you don't actually receive any interest payments. This results in paying tax on "phantom income" each year.

How can I avoid paying taxes on bonds?

Here are a few strategies for avoiding – or at least reducing – the taxes you pay on bonds.
  • Hold the bond in a tax-advantaged account. When you invest in bonds within a Roth IRA or Roth 401(k), the returns are tax-free, as long as you follow the withdrawal rules. Bond income and profits from sales earned within a traditional IRA or 401(k) are tax-deferred, meaning you don't pay taxes until you withdraw the money in retirement.
  • Use savings bonds for educational purposes. Consider using Series EE or Series I savings bonds to save for education. When you redeem the bond, the interest paid is tax-exempt as long as you use the money to pay for qualified higher education expenses and meet other qualifications.
  • Hold bonds until maturity. Holding a bond until maturity, instead of selling it early on the secondary market can help you avoid paying taxes on capital gains. However, you still owe tax on any taxable interest generated by the bond while you owned it.

Minimizing the tax consequences of bonds comes down to investing in tax-exempt bonds, such as muni bonds and US Treasuries, and using tax-advantaged accounts where your money can grow on a tax-free or tax-deferred basis.

If you invest in bonds outside of tax-advantaged accounts, you'll receive a Form 1099 from the bank or brokerage holding your investments around January 31 of each year. Hold on to these forms, as you'll need them to report bond interest and capital gains on your tax return. The IRS also gets a copy of those 1099s.

If you miss reporting any income, they'll be sure to let you know.

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