Lesson 14: Which bonds offer non-taxable interest?

Which bonds offer non-taxable interest?

November 26th, 2011 by

taxable, tax deferred, and tax exemptThe nice thing with bonds and other fixed income investments such as annuities, is that there are wonderful products that either provide tax free, or tax deferred income.  If you are in a relatively low tax bracket this is probably not going to play a major role in your investment choices. However, since your viewing this site, you are probably in a high tax bracket (or will be) and tax considerations are important to you.  Many people also change tax brackets as they age. Those in there 20s and 30s often mover into higher brackets, while those retiring often move into a lower brackets. You should keep in mind not only your current tax bracket but also what your tax bracket will be when receiving the income.

Tax Exemption

Taxes can originate at a federal, state and local level.  Some fixed income products are taxed at one level of government, but not at another. For instance, U.S. Treasury bonds are taxed federally, but are exempt from state and local taxes. Some products are exempt from all taxes in certain situations, an example being many municipal bonds which are issued in the same state where the purchaser resides.

Are Tax Exempt Bonds Always the Superior Choice?

Not necessarily. It will depend on your tax band. A ten year bond with tax exemption and a lower yield, compared to a ten year bond that is taxable but with a higher yield, may be of interest to investors in higher tax bands: these investors can leverage the tax exemption to end up with more money after taxes, despite the lower yield. Investors in lower tax bands won’t get the same benefit and may be better off taking the taxable, higher yield product.  We have a lesson on how to determine whether a taxable or tax exempt bond makes more sense for your situation here and a taxable vs. tax exempt calculator here.

Tax Deferral

In most cases the profits from an investment are taxed as they occur, regardless of when they are actually realized.  As an example, if you buy a 5 year zero coupon bond, you are taxed each year on the interest that has “accrued” for that year.  This is true even though the interest is not actually paid out to you until the 5 year maturity date.

Some investments, such as savings bonds and annuities, allow you to defer taxes on profits until they are actually paid out, or withdrawn from your account.  This is a major benefit, as the profits on your investment are also not taxed until that time.  When factoring in the additional compound interest that you are able to earn as a result, the difference in return between a taxable and tax deferred investment can be quite large.  As many people are in a lower tax bracket once they reach retirement, this is also an especially important consideration for those who are saving for retirement.

If you are holding your investments in a retirement account such as an IRA or 401K, then tax deferred investment options do not offer you any additional benefit.  As the tax deferral benefit of an investment generally comes at the price of a interest rate, they should generally be considered only when investing outside of your retirement account.

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