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
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.
What makes a bond taxable? ›
Capital gains, which are any profit you make from selling a bond before maturity. (Capital losses are also possible.) The tax rate charged will depend on how long you held the bond. If you've held it for less than a year, you'll be charged at your regular income tax rate.
What is a tax bond? ›
A tax bond is a type of financial guarantee bond that may be required for your business if you operate in certain areas. Here at Surety by NFP, one of the main products we offer are sales tax bonds.
What are bonds and how do they work? ›
A bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments, corporations and municipalities issue bonds when they need capital. An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money.
Are taxable bonds fixed-income? ›
A taxable municipal bond is a non-tax-exempt fixed-income security issued by a local government to finance projects that the federal government will not subsidize. In this article we explain what taxable municipal securities are, why you should invest in them and how they fit into your portfolio.
What type of bonds are not taxable? ›
Income from bonds issued by the federal government and its agencies, including Treasury securities, is generally exempt from state and local taxes.
How do I know if a bond is taxable? ›
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.
Do you need to put bonds on your taxes? ›
In general, you must report the interest in income in the taxable year in which you redeemed the bonds to the extent you did not include the interest in income in a prior taxable year.
Who pays taxes on bonds? ›
Generally, taxes are owed on interest earned if you're the only bond owner or you use your own funds to buy a bond that you co-own with someone else. If you buy a bond but someone else is named as its only owner, they would be responsible for the taxes due.
How do I avoid bond tax? ›
You can exclude the interest from your series EE and series I U.S. savings bonds on Form 8815 of the 1040. Form 8815 helps calculate the amount of interest that you can exclude from your tax return. If all the interest was not used for a qualified higher education expense you will stay pay taxes on that amount.
Tax Credit Bonds provide periodic tax credits to the holders of the bonds. Direct Pay Bonds are a type of tax credit bond for which the issuer has elected to receive direct payments from the federal government instead of the tax credits that would otherwise be allowed to holders of the bonds.
How do bonds work examples? ›
Characteristics of Bonds
For example, say an investor purchases a bond at a premium of $1,090, and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
How do bonds work for beginners? ›
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.
How do bonds work for dummies? ›
The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.
What is the difference between a taxable bond and a municipal bond? ›
Tax Liability: Unlike municipal bonds, the interest earned on taxable bonds is subject to federal, and possibly state and local, income taxes. This reduces the net income for investors, particularly those in higher tax brackets.
What are taxable and non taxable bonds? ›
What's taxable? What's not? The interest on corporate bonds is taxable by local, state, and federal governments. However, interest on bonds issued by state and local governments (generically called municipal bonds, or munis) generally is exempt from federal income tax.
What is the difference between taxable bonds and tax-exempt bonds? ›
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 to tell if a municipal bond is taxable? ›
Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income.
