What Are the Taxation Rules for Bond Investors?
Every year, bondholders ritually fill out IRS tax form 1099-INT, 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.
The interest from Treasury bills, notes, bonds, and U.S.government agency securities is only taxable at the federal level. Some agency securities, such as the Ginnie Mae - Government National Mortgage Association (GNMA), are also only taxable at the federal level.
Taxation of Zero-Coupon Bonds
Although they have no stated coupon rate, zero-coupon investors must report a pro-rated portion of interest each year, as income, even though interest hasn’t been paid out. Zero-coupon bonds are issued at discounts and they mature at par values, where the amount of the spread is divided equally among the number of years to maturity. They are consequently taxed as interest, just like any other original issue discount bond.
Savings bonds are deemed safe investment vehicles, with many benefits. Series E and EE savings bonds are also state and local tax free, however their 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.
Taxation Rules for Bond Investors
The Fast Facts
- While IRS tax form 1099-INT offers bondholders straightforward guidelines for declaring tax on income generated from the stated rate of interest, there are often complex factors that fixed income investors must heed.
- There are different taxation rules for government, corporate and 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.
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 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.
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 pro-rated 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 pro-rated 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, he or she 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.