Bonds are an essential component in diversifying your investment portfolio.
Sadly, they create a rather taxing situation when April rolls around.
In theory, the rules behind form 1099-INT are straightforward. In practice, the tax rules are many and varied as the types of bonds. Here’s how taxes on bonds work and what you need to be aware of.
What are Bonds?
Before we talk about how bonds are taxed, it’s important to understand what bonds are and how they work.
A bond is a debt security. When you buy a bond, you’re loaning money to the issuer on the agreement that the issuer will pay a specified interest rate over the life of the bond, as well as the principal value of the bond after a predetermined period of time.
Bonds may be issued by a government, corporation, or municipality. They’re also a reliable source of income, as bond interest is usually paid twice a year, and they help offset exposure to more vulnerable financial holdings.
You earn money on your investment through the interest rate paid on the bond, as well as repayment of the principal sum. You won’t get the principal back if you don’t hold the bond to maturity.
Types of Bonds
The types of bonds available to you depend on who you’re purchasing them from. Common types of government bonds include:
- Government bonds, including treasury bills, bonds, notes, and U.S. agency securities
- Zero-coupon bonds, which are offered for a discount at the time of sale and don’t pay annual interest
- Municipal bonds, which are offered by state or local governments
- Savings bonds
There are also corporate bonds, which have a higher yield and higher risk than government-issued bonds. After all, the federal or state government won’t go under, but a company could go under before the bond reaches maturity.
Since each of these types of bonds is structured differently, each bond is taxed differently.
Individual vs. Funds
The first big distinction is whether you’re being taxed on an individual bond or a bonds fund. Bonds and bond funds are both taxed in two ways:
- Distributed income
- Capital gains if the investment is sold at a profit
Let’s break it down.
Individual bonds are sold with a finite maturity. They also come with a commitment–the issuer will pay a defined amount of income at predetermined intervals.
They also allow you to buy into a fixed rate of return, or fixed yield, at the time of purchase. This allows you to figure out a total return, either yield to maturity or yield to call.
Fortunately for investors, the tax implications of individual bonds are pretty straightforward.
If you receive income on a bond, you’ll be taxed on it for the year that income was received. So, if an issuer pays you interest twice in 2019, you’ll pay taxes on that interest in your tax returns for 2019 (just make sure you put it in the right place on your tax return).
The level at which you’re taxed (local, state, federal) depends on the bond. Municipal bonds usually aren’t subject to federal income tax and may not be subject to state or local income tax either, but it’s best to consult a tax professional on this.
Capital gains are an increase in the value of capital assets. Basically, it’s profit.
If you bought a bond when it was issued, at its original issue price, and held the bond to maturity, you generally aren’t subject to capital gains tax.
If you bought the bond on a secondary market for a discount rate, things get complicated. The exact capital gains or loss tax you’re subject to will depend on your tax elections.
Then, there are bond funds.
Bond funds are just like stock mutual funds–you put your money into a pool with other investors and an investment professional takes that pool and invests it based on what they believe your best opportunities are.
The exact rules and choices depend on the fund’s stated investment goals. Regardless of the focus, bond funds typically invest in a wide range of securities, which makes it easier to diversify your portfolio than you would with a smaller investment.
The income and capital gains from these investments are distributed among the investors, who pay taxes based on their allotment of the investment.
Since you’re not earning income as an individual, the tax implications are a bit different.
As a rule, the interest generated is calculated daily and distributed to investors monthly. It’s taxed at the federal and state level in the same year you receive the income.
As with individual municipal bonds, municipal bonds purchased through a bond fund can have strange loopholes where federal, state, and local income taxes are concerned, so it’s important to speak with a tax specialist to ensure that you’re paying taxes on them properly.
Capital gains on bond funds are a bit more complicated than capital gains on individual bonds. That’s because there are two types of capital gains that you can generate from bond funds:
- Capital gains and losses incurred by the fund manager
- Capital gains and losses incurred when you sell shares of the fund
Capital gains and losses incurred by the fund manager will tell you what portion of your income is attributable to interest income, capital gains, and capital losses. How it’s classified will change what taxes you owe on it.
When you sell shares of the fund, you’ll incur a gain or loss based on three things:
- The amount of your initial investment
- Your cost basis
- Your reinvested dividends, if any
After that, it’s relatively simple. Capital gains are taxable as income, and capital losses can provide a tax benefit for the year you incurred them.
Taxes on Bonds by Type of Bond
With all of that in mind, there are specific tax rules attached to each type of bond.
Federal Government Bonds
Bonds issued by the federal government are fairly straightforward.
Any of these bonds, including Treasury bills, notes, bonds, and agency securities, are only taxable at the federal level. State and local income taxes don’t apply.
The only government-issued bond that makes things slightly complicated is a zero-coupon bond.
If you recall, zero-coupon bonds are purchased at a discount and don’t pay out annual interest.
Zero-coupon bonds require investors to report a pro-rated portion of interest each year as though the interest is income, despite the fact that the interest hasn’t been paid out yet.
That’s because the IRS computes the “implied” annual interest rate (the interest rate you would have gotten if you had purchased the bond as a normal bond) and holds you liable for that interest as income.
It doesn’t matter that you won’t see any of that money until the bond matures–you still need to pay it if you want to avoid an audit.
Yes, you’re going to pay taxes on an income you haven’t received, won’t receive for several years, and may not receive at all. Welcome to the joy of taxes.
As you might have guessed, municipal bonds are a somewhat fussy type of bond.
So long as you buy the bond from the issuer in the same state and municipality that the bond was issued from, the bond is free from federal, state, and local income taxes.
If you buy municipal bonds on the secondary market and sell them before they reach maturity, you’ll be subject to capital gains or losses tax. The long-term and short-term tax rates depend on the gains you incurred.
Finally, there are corporate bonds. These are the simplest bonds from a tax perspective, which is a relief considering that they’re also the highest risk bond.
Unfortunately, since corporate bonds have the highest interest rates of any bonds, corporate bonds are simple in the worst way: they have zero tax-free provisions.
If you owe 100 corporate bonds at $1,000 par value, each paying 7% annually, you have $7,000 in taxable interest income each year. No ifs, ands, or buts.
Need Help Figuring Out Your Taxes?
Let’s be honest: figuring out taxes on bonds is a nightmare. But it can be a lot easier if you have a tax attorney to help iron things out.
That’s where we come in.
If you need to speak with us about your options, use our contact page to get in touch.