Taxation Rules For Bond Investors

Every year, bondholders receive their annual 1099-INT forms and dutifully report the numbers that are listed there on their tax returns. However, there is often more to what appears on these forms than the income that is generated from the stated rate of interest. Many fixed income investors are unaware of a number of factors that can impact the amount of taxable interest that they must report at the end of the year. This article will explore each of the major categories of bonds, as well as analyze some of the other issues that factor into what investors must report as income.

Types of Bonds
All bonds fall into one of three broad categories:

  • Government
  • Corporate
  • Municipal

Although certificates of deposit (CD) can trade like bonds in the secondary market and are taxed in a similar manner, they are not considered to be bonds. The following is a breakdown of each type of debt.

Government Bonds
The interest from Treasury bills, notes and bonds as well as U.S. government agency securities is taxable at the federal level only. Some agency securities, such as the Ginnie Mae - Government National Mortgage Association (GNMA), are also taxable at the federal level.

Taxation of Zero-Coupon Bonds
Despite the fact that they have no stated coupon rate, zero-coupon investors must report a prorated portion of interest each year as income, even though it has not been paid out. Zeros are issued at a discount and mature at par, and the amount of the spread is divided equally among the number of years to maturity and taxed as interest, just as any other original issue discount bond. (For related reading, see Weighing The Tax Benefits Of Municipal Securities.)

Savings Bonds
Series E and EE savings bonds are also state and local tax free, except that the interest on them may be deferred until maturity. Series H and HH bonds pay taxable interest semiannually until maturity. Series I bonds also pay taxable interest, which may be deferred like Series E/EE bonds. The interest from Series E and I bonds may also be excluded from income if the proceeds are used to pay higher education expenses. (For more insight, read The Lowdown On Savings Bonds.)

Municipal Bonds
Municipal bonds are generally appropriate for high-income investors who are seeking to reduce their taxable investment incomes. The interest from these bonds is tax free at the federal, state and local levels as long as the investor resides in the same state or municipality as the issuer. However, if you buy municipal bonds in the secondary market and then sell them later at a gain, that gain will be taxable at ordinary long- or short-term capital gain rates. Municipal bonds pay a commensurately lower rate than other bonds as a result of their tax-free status. If you want to accurately compare the return you will receive from a municipal bond versus a taxable bond, you must compute its taxable equivalent yield. The formula is as follows:

Taxable Equivalent Yield = Tax-Free Yield / 1 - Your Tax Bracket


Example - Taxable Equivalent Yield
Joe is trying to decide whether he should invest in a corporate or municipal issue. He is in the 26% tax bracket. The municipal bond is paying 5% and the corporate issue pays 8%. Which is the best choice?

8% = 5/100 - 26
8% = 5/74
8% = 0.067 or 7%
In this case, the corporate obligation will pay Joe more than the municipal issue. This is true for most investors in the lower tax brackets. (For more, see The Basics of Municipal Bonds and Avoid Tricky Tax Issues On Municipal Bonds.)

Corporate Bonds
Corporate bonds are the simplest type of bond from a tax perspective, as they are fully taxable at all levels. Because these bonds typically contain the highest level of default risk, they also pay the highest rates of interest of any major category of bond. Therefore, an investor who owns 100 corporate bonds at $1,000 par value each paying 7% annually can expect to receive $7,000 of taxable interest each year. (For more insight, read Corporate Bonds: An Introduction To Credit Risk.)

Capital Gains
Regardless of the type of bonds that are sold, any debt issue that is traded in the secondary market will post either a capital gain or loss, depending on the price at which the bonds were bought and sold. This includes government and municipal issues as well as corporate debt. Gains and losses on bond transactions are reported the same as with any other type of security, such as stocks or mutual funds, for the purposes of capital gains. (For related reading, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)

Amortization of Bond Premium
As discussed previously, when a bond is issued at a discount, a prorated portion of the discount is reported as income by the taxpayer each year until maturity. When bonds are purchased at a premium (greater than $1,000 per bond), a prorated portion of the amount over par can be deducted yearly on the purchaser's tax return. For example, if you buy 100 bonds for $118,000 and hold them for 18 years until they mature, you can deduct $1,000 each year until maturity. You also have the option of deducting nothing each year and simply declaring a capital loss when you redeem the bonds at maturity or sell them for a loss.

However, it is not necessary to amortize premium in the year that you buy the bond; you can begin doing so in any tax year. One important rule to remember is that if you elect to amortize the premium for one bond, then you must also amortize the premium for all other similar bonds, both that year and going forward. Another caveat is that if you do decide to amortize the premium from a bond, you must reduce the cost basis of your position by an equivalent amount.

Conclusion
For further information on bond taxation, download IRS Publication 1212: Guide to OID Instruments. If taxable bond income is a major component of your annual taxes, consider hiring a certified public accountant to assist you in annual tax planning strategies.

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