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.

Related Articles
  1. Investing News

    Bill Gross: It's a Xanax Existence for the 99%

    Read about the investment letter from famed bond king Bill Gross for 2016. See how he says the 99% are living a Xanax existence while the 1% prosper.
  2. Mutual Funds & ETFs

    Pimco’s Top Funds for Retirement Income

    Once you're living off the money you've saved for retirement, is it invested in the right assets? Here are some from PIMCO that may be good options.
  3. Retirement

    Retirees: How to Survive When Interest Rates Drop

    Low interest rates are a portfolio killer if you're living off of investment income. Some strategies for dealing.
  4. Investing News

    Hillary Clinton's Liberal Orthodoxy

    Clinton's economic agenda laid out in July is divided into three broad groups: strong growth, fair growth and long-term growth. And her overarching goal is to "give working families a raise."
  5. Investing News

    Bernie Sanders: Socialist or Liberal?

    Sanders' pitch centers on economic inequality in the U.S., which is both more severe than it is in other developed countries and, if current trends continue, projected to worsen.
  6. Taxes

    Why People Renounce Their U.S Citizenship

    This year, the highest number of Americans ever took the irrevocable step of giving up their citizenship. Here's why.
  7. Products and Investments

    There's a Reason They're Called Junk Bonds

    The closing of Third Avenue Managemet's Focused Credit Fund is a warning to investors and advisors. Beware the junk.
  8. Investing News

    Obama Floats $10 a Barrel Oil Tax

    President Obama intends to propose a $10 a barrel tax on oil; consumers might have to cough up 25 cents more per gallon.
  9. Investing Basics

    The Pros and Cons of Distressed Debt Investing

    Distressed debt investing is suitable for professional investors. Besides heavy risk factors to consider, this investment type can provide a large ROI.
  10. Investing

    How Rising Interest Rates Affect Junk Bonds

    We examine the impact of rising interest rates on higher-yielding bonds.
RELATED FAQS
  1. How is face value used to determine taxation?

    Corporate and government bonds are the most common taxable instruments with listed face values, although there are others ... Read Full Answer >>
  2. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
  3. How do I file taxes for income from foreign sources?

    If you are a U.S. citizen or resident alien, your income (except for amounts exempt under federal law), including that which ... Read Full Answer >>
  4. How Long Should I Keep My Tax Records?

    The Internal Revenue Service (IRS) has some hard and fast rules regarding how long taxpayers should keep their tax records. As ... Read Full Answer >>
  5. Are personal loans tax deductible?

    Interest paid on personal loans is not tax deductible. If you take out a loan to buy a car for personal use or to cover other ... Read Full Answer >>
  6. Does a Flexible Spending Account (FSA) cover braces?

    Funds from a Flexible Spending Account (FSA) can be used to cover costs associated with installing, maintaining and removing ... Read Full Answer >>
Trading Center