A bond is a fixed income carrying interest rate (coupon rate). When you purchase the bond, you earn interest on the amount of the bond. The rate of interest is fixed for the life of the bond. The bond investor has to pay the tax on this interest. Some bonds' interests are taxable and some are exempt from taxes. It depends on the type of bond.
Most of the bonds are taxable and only a few are tax-exempt bonds. Taxable bonds are debt security that has to be paid from the bondholder. Therefore, the investor always thinks deeply before investing in bonds that either he needs to invest in taxable bonds or tax-exempt bonds. In this article, you will find about the finer points of bonds interests and taxation rules on different types of bonds.
How Bonds Are Taxed?
Bonds are taxed based on their income. Bonds generate two types of income: Interest and Capital Gain.
A bond is a kind of debt instrument. When you buy the bond, you are lending money to the government or company, in return, that entity pays you interest. Interest is one of the incomes generated by bonds. You earn a fixed amount of interest on the amount of bond.
Some income interest can be taxable and tax-exempt. It depends on the type of bond that generated interest income. If the interest or bond is taxable, you will have to pay the tax on that interest. If the bond is tax-exempt that generates the interest, sometimes you need to include the tax on the tax return. Because the IRS adds it in some calculations, in the case of tax-free bonds.
Capital gain is the income generate from bonds. If you purchase the bond when it is issued and hold it until maturity (its lifespan), you will not recognize capital gain or loss. Moreover, if you sell the bond before the maturity date for more amount than you invested in it, you will have a capital gain.
On the other hand, if you sell it for less amount than you invested in it, you will have a capital loss. The money you get back in return for your investment is considered capital gain or loss. Just like interest, capital gains are also taxed but it depends on whether they are short-term or long-term.
Taxable and Tax-exempt Bonds
If you are thinking that are all bonds taxed? You will find the answer in this section. Bonds are divided into two categories: Taxable Bonds and Tax-exempt bonds.
A corporate Bond is the main type of taxable bond. They are fully taxable at all levels. Some more taxable bonds include:
· Global Bond Funds
· Diversified Bond Funds
· Mortgage-Backed Securities
Corporate bonds are the simplest type of bonds from a tax perspective. These bonds offer higher interest rates as compared to other types of bonds. But they contain the highest level of default risk. Corporate bonds are also known as high-yield bonds because they pay the highest interest rates. Companies issue corporate bonds. The investor who buys corporate bonds will have to pay tax on this interest amount.
Tax-exempt bonds include:
· Municipal Bonds
· US Treasury Bonds
Municipal bonds are the main type of tax-exempt bonds. These bonds are issued by states, cities, countries, or local governments. High-income investors prefer to buy municipal bonds to decrease taxable investment income. Municipal bonds generate tax-free interest at the local level. These types of bonds are issued to pay for big capital projects. When it comes to interest amounts, municipal bonds pay low-interest rates than other bonds due to their tax-free status.
US Treasury Bonds
US Treasury bonds are issued by the US government and they are safe investments. These bonds are free from taxes at the state level. Also, they pay low-interest rates. These bonds can be bought directly from the US government without the need for any broker.
The Bottom Line
If you're thinking to invest in bonds, you need a broker to buy them. If taxable bond interest is a major constituent of your taxes, it is recommended to hire an accountant to assist you in tax planning. The tax implications on bonds are straightforward. Income derived from interest is liable to tax.
In order to meet long-term goals, tax-exempt bonds are not recommended to create wealth. It is good to go for taxable bonds. Therefore, invest in bonds properly after evaluation of tax rate, long-term needs, and other things.