Each year, bondholders receive IRS tax Form 1099-INT or Form 1099-OID to report their annual taxable interest income when filing tax returns. This document offers guidelines for declaring tax on income generated from interest and bond taxation rules for government, corporate, and municipal bonds vary.
Key Takeaways
- The interest earned on fixed-income investments like bonds and notes is often subject to income tax.
- There are different taxation rules for government, corporate, and municipal bonds.
- IRS tax form 1099-INT is sent to bondholders who declare tax on income generated from interest.
Government Bonds
The interest from Treasury bills, notes, and bonds is taxable at the federal level but not at the state and local levels. Some U.S. government agency securities, such as those issued by Fannie Mae, are taxable at the federal level but exempt from state and local taxes.
Zero-Coupon Bonds
Although they have no stated coupon rate, zero-coupon investors must report a prorated portion of interest each year as income. Zero-coupon bonds are issued by governments at discounts, and they mature at par values, where the amount of the spread is divided equally among the number of years to maturity. Consequently, zero-coupon bonds are taxed as interest, just like any other original issue discount bond.
Savings Bonds
Savings bonds are issued by governments to the public and are deemed safe investment vehicles with many benefits. Series EE savings bonds are also state and local tax-free, and the federal taxes on interest income may be deferred until maturity.
Another bond type that also pays taxable interest is the Series I bond. The interest from Series EE and I bonds issued after 1989 may also be excluded from income if the proceeds are used to pay higher education expenses.
Municipal Bonds
Often held by high-income investors, municipal bonds can reduce 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 gainsrates, for any incurred gains.
Corporate Bonds
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 ratesof any bond. 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.
Tax-deferred accounts, such as individual retirement accounts (IRA) or 401(k), investing in corporate bonds with higher yields may be an advantage despite the lack of tax benefits that municipal bonds offer.
Capital Gains
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 capital gains.
Amortization of Bond Premium
The amortizable bond premium refers to the excess price paid for a bond above its face value. The premium paid represents part of thecost basisof the bond, can be tax-deductible, and amortized over the lifespan of the bond. Amortizing the premium can be advantageous since the tax deduction can offset any interest income the bond generates, thus reducing an investor's taxable income.
What Bonds Are Tax-Free?
Investors don't pay state and local taxes on government bonds or savings bonds but must pay federal taxes. Municipal bonds can avoid taxes altogether if investors live in the area where the "muni" is issued.
What Is a Corporate Bond?
A corporate bond is a type ofdebt security issued by a corporationto raise capital and then sold to investors. In return for the bond purchase, the investor is paid interest at either a fixed or variable interest rate.
How Are Bonds Treated on Tax Returns?
Bond income is reported alongside any other interest income earned during the year which may include interest income in savings accounts, certificates of deposit (CDs), and similar products. Investors receive IRS Form 1099-INT from all the entities that paid interest on their investments during the tax year.
The Bottom Line
Depending on the type of fixed-income security an investor purchases, there can be different tax implications for investing in bonds. If taxable bond income is a main component of a taxpayer's annual taxes, they can consult a certified public accountant (CPA) to assist them in tax planning strategies.
