Taxation Rules for Bond Investors

Every year, bondholders receive IRS tax form 1099-INT and use it to report their annual taxable interest income. While at first glance, this document offers straightforward guidelines for declaring tax on income generated from the stated rates of interest, there are often complex factors fixed income investors must heed. This article explores the finer points of bond taxation rules for government, corporate, and municipal bonds.

Government Bonds

The interest from Treasury bills, notes, and bonds is taxable at the federal level but not at the state and local levels. Certain U.S. government agency securities are also taxable at the federal level but exempt from state and local taxes. This includes bonds from the Federal Home Loan Bank, Financing Corporation, and Tennessee Valley Authority, among others.

Taxation of Zero-Coupon Bonds

Although they have no stated coupon rate, zero-coupon investors must report a prorated portion of interest each year, as income, even though interest hasn't been paid out. 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. Series E and EE savings bonds are also state and local tax-free, and the federal taxes on interest income may be deferred until maturity.

Series H and HH bonds pay taxable interest semi-annually until maturity, while Series I bonds also pay taxable interest, which may likewise be deferred. The interest from Series E and I bonds may also be excluded from income if the proceeds are used to pay higher education expenses.

Municipal Bonds

Municipal bonds are often favored by high-income investors looking to reduce their taxable 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, then later sell them, may be taxed at ordinary long- or short-term capital gains rates, for any incurred gains. Municipal bonds pay a commensurately lower rate than other bonds as a result of their tax-free status.

Corporate Bonds

Deemed the simplest type of bond, from a tax perspective, corporate bonds are fully taxable at all levels. Because these bonds typically contain the highest level of default risk, they also pay the highest interest rates of any major category of a bond. Therefore, 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 each year.

Capital Gains

Regardless of the type of bonds sold, any debt issue 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 way as other securities, such as stocks or mutual funds, for the purposes of capital gains.

Amortization of Bond Premium

As discussed, when a bond is issued at a discount, a prorated portion of the discount is reported as income by the taxpayer, every 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 annually on the purchaser's tax return.

For example, if an investor buys 100 bonds for $118,000 and holds them for 18 years until they mature, they may deduct $1,000 each year until maturity. That investor would also enjoy the option of deducting nothing each year and simply declaring a capital loss when either redeeming the bonds at maturity or selling them for a loss.

However, it is not necessary for investors to amortize premiums in the year they buy the bond, because they may begin doing so in any tax year. But it's important to remember that investors who elect to amortize the premium for one bond must also amortize the premium for all other similar bonds, both for that year and for years going forward. Furthermore, investors who amortize the premium from a bond must reduce the cost basis of their positions by equivalent amounts.

The Bottom Line

There can be different tax implications for investing in bonds, depending on the type of fixed-income security you purchase. If taxable bond income is a major component of your annual taxes, you could consider hiring a certified public accountant (CPA) to assist you in annual tax planning strategies.