Tax Rules for Bond Investors

Reviewed by Lea D. UraduFact checked by Vikki VelasquezReviewed by Lea D. UraduFact checked by Vikki Velasquez

Those who invest in bonds can owe taxes on interest income and capital gains. Each year, bondholders receive IRS Form 1099-INT (or Form 1099-OID) from entities that paid them interest on the bonds in which they invested. Investors use this form to help them report their annual taxable interest income when filing tax returns.

Since tax rules for bond investors can vary depending on whether you invested in government, corporate, or municipal bonds, it’s important to understand the rules that may apply to you, based on your holdings.

Key Takeaways

• The interest earned on fixed-income investments like bonds and notes is often subject to income tax.
• There are different taxation rules for government, corporate, and municipal bonds.
• IRS Form 1099-INT is sent to bondholders who declare income that results from interest payments.
• Investors will owe taxes on any capital gains they receive from bond transactions.

Government Bonds

The interest from Treasury bills, notes, and bonds is taxable at the federal level but not at the state and local levels. In addition, some U.S. government agency securities, such as those issued by Fannie Mae, are taxable at the federal level but exempt from state and local taxes.

Zero-Coupon Bonds

Although they have no stated coupon rate, zero-coupon bond investors must report a prorated portion of interest each year as income.

Zero-coupon bonds are issued by governments at discounts, and they mature at par values, where the amount of the spread is divided equally among the number of years to maturity. Consequently, zero-coupon bonds are taxed as interest, just like any other original issue discount bond.

Savings Bonds

Savings bonds are issued by governments to the public and are deemed safe investment vehicles with many benefits. U.S. government Series EE savings bonds are free from state and local tax, and the federal taxes on interest income may be deferred until maturity. The Series I savings bond is also free from state and local tax.

The interest from Series EE and I bonds issued after 1989 may also be exempt from federal taxes if the proceeds are used to pay higher education expenses.

Municipal Bonds

Often purchased by high-income investors, municipal bonds can mean tax-free investment income. The interest from these bonds is tax free at the federal, state, and local levels, as long as investors reside in the same state or municipality as the issuers.

However, those who buy municipal bonds in the secondary market and later sell them for a capital gain may be taxed at ordinary long- or short-term capital gains rates.

Corporate Bonds

Interest earned from corporate bonds is fully taxable at all levels. Because these bonds typically have the greatest risk of default, they pay the highest interest rates of any bond. Investors who own 100 corporate bonds at $1,000 par value, with each paying 7% annually, can expect to receive $7,000 of taxable interest income each year.

When investing through your tax-deferred account (such as an individual retirement account (IRA) or 401(k)), buying corporate bonds with high yields may give you a return advantage over municipal bonds in a taxable account, despite the tax benefits that municipal bonds offer.

Capital Gains

Capital gains are different from interest income paid by bonds. Regardless of the type of bond, any debt issue purchased and sold in the secondary market will post a capital gain (or loss). This includes government and municipal issues, as well as corporate debt. Gains and losses on bond transactions are taxed the same way that other securities, such as stocks or mutual funds, are taxed. That is, at the appropriate capital gains tax rate.

Amortization of Bond Premium

The amortizable bond premium refers to the price paid for a bond above its face value. The premium paid represents part of the cost basis of the bond, can be tax-deductible, and amortized over the lifespan of the bond. Amortizing the premium can be advantageous since the tax deduction can offset any interest income the bond generates, thus reducing an investor’s taxable income.

What Bonds Are Tax Free?

While investors will pay federal taxes on the interest income from government bonds, they won’t owe state and local taxes. Investors in municipal bonds can avoid taxes altogether if they live in the area where the muni is issued.

What Is a Corporate Bond?

A corporate bond is a type of debt security issued by a corporation and sold to investors to raise capital. In return for the bond purchase, the investor is paid interest at either a fixed or variable interest rate.

How Are Bonds Treated on Tax Returns?

Bond income is reported alongside any other interest income earned during the year, which may include interest income from savings accounts, certificates of deposit (CDs), and similar products.

The Bottom Line

The tax implications for investors in fixed income can vary, according to the type of security that they purchase. If taxable bond income is a main component of a taxpayer’s annual taxes, they can consult a certified public accountant (CPA) to assist them with tax planning strategies that may reduce what they owe.

Read the original article on Investopedia.