Bonds and Taxes
Taxes on bonds can make a huge difference in the return you earn, and therefore which type of bond you should buy. If you hold a bond to maturity, the only type of tax you will pay is income tax on the interest payments you earn over the life of the bond. There are major differences in how interest income from a bond is taxed, depending on the type of bond you are invested in.
To see a list of high yielding CDs go here.
Not all tax-exempt bonds are created equal. Municipal bonds in many situations have far greater tax advantages than Treasury bonds, as they are exempt from federal income tax, which is a lot higher than state income tax.
Here are a few more details:
Taxes on US Treasury Bills, Bonds and Notes:
Interest is tax exempt from State and Local income taxes. Interest is not-exempt from federal income taxes, including the Alternative Minimum Tax.
Taxes on Municipal bonds:
Interest on municipal bonds is normally exempt from federal taxes. If you live in the same state where the bond is issued, then most municipal bonds are also free from state taxes as well. If you live in NYC, many municipal bonds issued in New York state may also be exempt from the city’s income tax.
When buying a municipal bond, its important to read the prospectus to find out the exact tax status of the bond.
There is a type of municipal bond that while exempt from the “normal” federal income tax is subject to the Alternative Minimum Tax (AMT). These bonds are called Private Activity Bonds and are used to raise funds for private corporations with the the permission of a municipal government. Also, regardless of where you live, bonds issued from Puerto Rico are tax free do to its unique political status.
Because of the large tax advantages offered by municipal bonds, they pay a lower interest rate than their “taxable equivalent”.
When looking at a municipal bond and a corporate bond, both with the same maturity and credit quality, the corporate bond will pay a higher interest rate. The corporate bond does not offer the same tax advantages of the municipal bond, and therefore must compensate the investor by offering a higher interest rate.
Due to income tax differences from state to state, as well as the different tax brackets an individual can fall into, the level of tax savings on municipal bonds varies.
Here is a Taxable vs. Non Taxable Bond Calculator which will allow you to input the yield on a municipal bond and convert it to its “taxable equivalent” yield, based on your state and income tax bracket.
Tax Issues For Non-Tax Exempt Bonds
Taxes on Corporate Bonds:
Corporate bonds offer none of the tax advantages of government bonds. You always pay federal tax on corporate bonds, and if your state and city have income taxes,you pay those as well.
Taxes on Zero Coupon Bonds:
While the interest payment on a zero bond comes in one lump sum at the bond’s maturity, the IRS does not wait until you receive the money to tax you on it. Interest on zero coupon bonds is taxed as if you received the interest for each year you hold the bond, at the end of that tax year.
Capital Gains are Taxed on Both Taxable and Tax-Exempt Bonds
Bond prices fluctuate over time, so if you sell a bond prior to its maturity date, you can also incur a profit or loss on the sale of the bond. This is called a capital gain or loss, and if incurred over a period less than 12 months is taxed at your ordinary income tax rate. If the holding period is over 12 months, you are taxed at the lower long term capital gains tax rate. Both taxable and tax exempt bondholders pay taxes on the portion of their return associated with capital gains.
There are additional tax consequences when a bond is bought at a premium or discount to its face value. When held to maturity, the discount or premium will effect the amount of income tax you pay. When sold prior to maturity, the tax question is more complicated. You can learn more about bonds and taxes here.
This lesson is part of our Free Guide to the Basics of Investing in Municipal Bonds. Continue to the next lesson here.