Lesson 13: How are bonds taxed?

How are bonds taxed?

November 26th, 2011 by

How Fixed Income Products are TaxedBonds and other types of fixed income investments get their returns  from (and are therefore taxed on) one or both of the following sources:

Income

This is the interest you are earning on the investment.  As the name suggests, all “fixed income” products will have some form of interest income.  Generally the income portion of your investment will be taxed at your ordinary income tax rate.  This is basically the same rate of tax that you pay on your salary income.  The exception here is tax exempt products which we discuss below.

Capital Gains

In addition to earnings from interest, many fixed income products can also generate a capital gain or loss in certain situations. As discussed in our article on bond price movements, if a bond is sold before it its maturity date, the price is likely to have changed from your purchase price.  This will generate a capital gain or loss which is treated separately from interest income from a tax standpoint .

For most investors capital gains which occur more than 12 months from the original purchase date, are taxed at a rate of 15%.   If the capital gain is taken within 12 months of purchasing the investment, then it will be taxed as a short term capital gain, the rate for which is generally the same as your ordinary income tax rate.

Bonds Purchased At A Premium Or Discount

When you buy a  bond at a premium or discount, the difference between the market price and face value will not generate a capital gain or loss, so long as you hold the bond to maturity. Instead, the difference will effect how you report interest to the IRS through the life of the bond. When you buy a bond at a premium, the interest you report on your taxes is actually lower than the dollar amount of the interest you receive. Conversely, a bond purchased at a discount will need to be reported at higher level than the interest you receive. For more details, see the article How To Report Bond Interest To the IRS.

Bond Mutual Funds

Because of differences in the way that income is distributed and how principal is accounted for, there are different tax considerations when investing in bond mutual funds vs. individual bonds.  For more on how bond mutual funds are taxed go here.

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