How Bonds Can Reduce Your Tax Burden - The Planning Center (2024)

FAQs

Does investing in bonds reduce taxes? ›

Interest on I bonds is exempt from state and local taxes but taxed at the federal level at ordinary income-tax rates.

Interest from Treasuries is generally taxable at the federal level, but not at the state level. Interest from munis is generally exempt from federal taxes, and if you live in the state where the bond was issued, the interest may also be exempt from state taxes.

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.

Generally speaking, bonds will tend to be less tax-efficient than stocks. That's because most of the return that bond investors earn is income, and that income is taxed at your ordinary income tax rate, which is higher than the capital gains and dividend tax rates that apply to the gains from most stock holdings.

Treasury bonds and Series I bonds (savings bonds) are also tax-efficient because they're exempt from state and local income taxes.

These are U.S. government bonds that offer a unique combination of safety and steady income. But while they are lauded for their security and reliability, potential drawbacks such as interest rate risk, low returns and inflation risk must be carefully considered.

Government debt and the 10-year Treasury note, in particular, are considered among the safest investments. Its price often (but not always) moves inversely to the trend of the major stock market indexes. Central banks tend to lower interest rates in a recession, which reduces the coupon rate on new Treasurys.

In other states, such as California, nearly all the municipal bonds are tax exempt. It is also worth considering investing in municipal bonds that are not tax exempt, even those issued in states other than your primary residence, as they can offer higher yields.

Which bonds are tax exempt? ›

Municipal Bonds

Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes.

Are all bonds taxed? Bonds are divided into two classes: taxable and tax-exempt. A bond's tax-exempt status applies only to the bond's interest income. Any capital gains generated from selling a bond or bond fund before its maturity date is taxable, regardless of the type of bond.

They are still taxable. The interest income of the savings bond will be taxed to the bond's owner—i.e., the recipient of the gift—when the bond matures and is redeemed for cash (or the owner will be taxed each year if they elect to report the interest income annually).

Bonds used to fund local and state government projects like buildings and highways are afforded tax-exempt status at the federal level. Plus, people who purchase bonds issued by their states or localities may not be required to pay state or local taxes on the interest.

Federal Tax Implications for Treasury Bond Investors

The interest earned on Treasury bonds is subject to federal taxes on treasury bonds, but it's exempt from state and local taxes. This federal tax applies to the interest payments that investors receive semi-annually.

What are the disadvantages of bonds? Although bonds provide diversification, holding too much of your portfolio in this type of investment might be too conservative an approach. The trade-off you get with the stability of bonds is you will likely receive lower returns overall, historically, than stocks.

The cons of investing in I-bonds

There's actually a limit on how much you can invest in I-bonds per year. The annual maximum in purchases is $10,000 worth of electronic I-bonds, although in some cases, you may be able to purchase an additional $5,000 worth of paper I-bonds using your tax refund.

Historically, bonds have provided lower long-term returns than stocks. Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.

The disadvantages of bond funds include higher management fees, the uncertainty created with tax bills, and exposure to interest rate changes.