What Is a Taxable Bond?

A taxable bond is a debt security (i.e. a bond) whose return to the investor is subject to taxes at the local, state, or federal level, or some combination thereof. An investor trying to decide whether to invest in a taxable bond or tax-exempt bond should consider what he or she will have left in income after taxes are taken.

Key Takeaways

  • Taxable bonds are subject to taxation from the bondholder.
  • Most bonds are taxable. Generally, only bonds issued by local and state governments, i.e. municipal bonds, are tax-exempt and even then special rules may apply.
  • You must pay tax on both interest payments and on capital gains if you redeem the bond before its maturity date.

How Taxable Bonds Work

All corporate bonds and some government bonds are taxable bonds. For example, Treasury securities are taxed at the federal level, but may be tax-exempt from local and state taxes.

As stated above, the majority of bonds issued are taxable bonds meaning their interest payments to investors are taxable at either the federal and/or state level. Fixed or variable interest on a bond is income paid to bondholders as compensation for lending the issuer funds for a fixed period of time. Those payments are called "coupon payments," and they are usually made annually, semi-annually, or quarterly depending on the terms and conditions highlighted in the bond purchase agreement.

At the end of the year, people who have invested in taxable bonds and have received interest income are required to include the amount of interest received on the bonds on their tax filings to their local and state governments and to the federal government. If the bonds were issued at a discount and held until maturity and then there were redeemed for face value, the bondholder would be liable for taxes on the spread.

Municipal Bonds and Tax Exemption

Municipal bonds, on the other hand, are not taxed at the federal level and may also be exempt from state taxes if the bondholder resides in the state where the bonds are issued.

Some municipal governments issue taxable bonds to finance projects that do not benefit the public at large. Interest from municipal bonds issued to finance projects with no obvious public benefit is taxable since the federal government will not subsidize the financing of these projects. Since income from such bonds is taxable in the hands of the investor, taxable municipal bonds offer risk-adjusted yields that are comparable to those available from other taxable entities such as corporate bonds and other government agency bonds.

For example, some universities, through municipal authorities, may issue taxable bonds to finance the building of new facilities or expansion of some department wings. These bonds, however, return the market rate as opposed to the lower return rate offered by tax-free bonds.

Examples of Taxable Bonds

Consider a zero-coupon bond and Treasury bill which do not pay interest for the duration of the bond’s life. Instead, they are offered at discounts and redeemed at par value on the maturity date. For example, an investor may purchase a bond for $950 and receives $1,000 face value at maturity. The $50 difference represents the return on the investment and is taxed as interest income.

Even though the bondholder does not receive interest income per se, the discount is considered imputed interest by the Internal Revenue Service (IRS) and must be reported at the end of the tax year. However, if the discount bond is sold before maturity, a capital gain or loss will ensue which must be reported in order to be taxed accordingly.