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 they 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 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.
FAQs
The discount is considered as capital gains and taxed at the applicable income tax rates. Example: Suppose you purchase a bond with a face value of ₹10,000 at a discount of 10%. This means you buy the bond for ₹9,000. The discount of ₹1,000 (₹10,000 face value – ₹9,000 purchase price) is considered as interest income.
How do taxable bonds work? ›
The income from taxable bond funds is generally taxed at the federal and state level at ordinary income tax rates in the year it was earned. Funds that exclusively hold U.S. Treasury bonds may be exempt from state taxes.
What is the meaning of tax bond? ›
For anyone asking themselves "What is a tax bond?," it's a financial guarantee bond that offers security for a business that will automatically cover all of the various sales taxes that are owed on a state and federal level.
What is the difference between a tax free bond and a taxable bond? ›
The main difference between a taxable municipal bond and a tax-exempt muni is that taxable munis pay interest income that's subject to federal and state income taxes, whereas tax-exempt munis pay interest income that's generally exempt from federal and state income taxes.
How do you calculate taxable bonds? ›
How Tax Equivalent Yields Are Calculated. The Tax-Equivalent Yield Calculator uses the following formulas to calculate tax-equivalent yields: Out-of-State Municipal Bond Yield = In-State Muni Bond Yield / (1 – Out-of-State Muni Bond Tax Rate) Treasury Bond Yield = In-State Muni Bond Yield / (1 – Treasury Bond Tax Rate)
What is an example of a bond income? ›
Most commonly bonds have a par value of $1,000. Coupon: The fixed rate of interest that the bond issuer pays its bondholders. Using the $1,000 example, if a bond has a 3% coupon, the bond issuer promises to pay investors $30 per year until the bond's maturity date (3% of $1,000 par value = $30 per annum).
Should I invest in taxable bonds? ›
What Are the Advantages and Risks of Investing in Taxable Bonds? The main advantage of taxable bonds is their ability to generate current income with relatively low risk. For this reason, taxable bonds can be a good choice for many investors' portfolios.
Do I have to pay taxes on my bonds? ›
Tax on interest
The interest you earn on corporate bonds is generally always taxable. Most all interest income earned on municipal bonds is exempt from federal income taxes. When you buy muni bonds issued by the state where you file state taxes, the interest you earn is usually also exempt from state income taxes.
How much tax will I pay on I bonds? ›
Interest on I bonds is exempt from state and local taxes but taxed at the federal level at ordinary income-tax rates.
How do bonds work? ›
Bonds are an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.
Individuals do not pay tax on their bond gains until a chargeable event occurs. This tax 'deferral' is one of the features that sets bonds aside from other investments. However, when a chargeable event does occur, a gain will be taxed in the tax year of that event.
Do bonds go on tax return? ›
Interest from your bonds goes on your federal income tax return on the same line with other interest income.
What are taxable bond funds? ›
Fixed-income funds that distribute income that is subject to taxation at the federal, state, and sometimes local levels.
What is an example of a taxable municipal bond? ›
Other situations where taxable municipal bonds may be issued include financing local sports facilities, funding infrastructure-related repairs or investor-led housing, or refinancing debt. Build America Bond (BABs) are an example of taxable municipal bonds.
How do I avoid bond tax? ›
The Treasury gives you two options:
- Report interest each year and pay taxes on it annually.
- Defer reporting interest until you redeem the bonds or give up ownership of the bond and it's reissued or the bond is no longer earning interest because it's matured.
Here are some of the key asset classes that make sense for most investors' taxable accounts:
- Municipal Bonds, Municipal-Bond Funds, and Money Market Funds.
- I Bonds, Series EE Bonds.
- Individual Stocks.
- Equity Exchange-Traded Funds.
- Equity Index Funds.
- Tax-Managed Funds.
- Master Limited Partnerships.
Bonds typically pay a fixed amount of interest (usually paid twice per year). Interest from corporate bonds and U.S. Treasury bonds interest is typically taxable at the federal level. U.S. Treasuries are exempt from state and local income taxes.
Are all Treasury bonds taxable? ›
Interest income from Treasury securities is subject to federal income tax but exempt from state and local taxes. Income from Treasury bills is paid at maturity and, thus, tax-reportable in the year in which it is received.
What is an example of a tax-exempt bond? ›
Examples of Exempt Facility Revenue Bonds
Typical examples are terminals, hangars, aircraft repair facilities, freight forwarding/warehousing facilities, etc. If tax-exempt bonds are to be used to finance such facilities, certain limitations and conditions exist.
