- Bonds and bond funds generate two types of income: interest and capital gains.
- Interest income from a bond may be taxable or tax-exempt, depending on the type of bond.
- Capital gains from the sale of a bond before maturity are always taxable, unless it is in a tax-advantaged account.
Like most investments, a bond can make money for investors in two ways: through fixed interest payments when an investor holds it for a period of time, or by selling it at a higher price than when it was first purchased. time. Unfortunately, like most investments, bonds are also subject to
Capital gains
taxes.
How are bonuses taxed?
Bonds generate two different types of income: interest and capital gains.
Interest
Bonds are a type of debt security. When you buy a bond, you are lending money to the government or company that issued it. That entity can leverage that money to boost yields and pays you back in the form of periodic interest payments and a return of principal once the bond matures. Most bonds pay a fixed, predetermined rate of interest over their life, usually at semi-annual or annual intervals.
That interest income may be taxable or tax-free (more on the types of bonds that generate tax-free income later). For the most part, if the interest is taxable, you pay income taxes on that interest in the year it is received.
The rate you will pay for interest on the bonds is the same rate you pay for your ordinary income, such as wages or self-employment income. There are seven tax brackets, ranging from 10% to 37%. So if you’re in the 37%
tax bracket
will pay 37% federal
income tax
interest rate on your bond.
Capital gains
If you buy a bond when it’s first issued and hold it to maturity, throughout its useful life, you generally won’t recognize a capital gain or loss. The money you get back is considered a return on your capital, what you originally invested in it.
However, after they are issued, bonds are often traded on financial exchanges, much like stocks. If you sell them before their maturity date in the secondary market, the bonds can generate capital gains and losses, depending on how their current price compares to their original cost. Bond funds can also generate capital gains and losses as the fund manager buys and sells securities within the fund.
Therefore, the gain you make from the sale of a bond is considered a capital gain. Capital gains are taxed at different rates depending on whether they are short-term or long-term.
Short-term capital gains apply if you hold the bond for one year (365 days) or less. The gain is then taxed at your regular income tax rates.
Long-term capital gains apply if you hold the bond for more than one year. You can then benefit from reduced tax rates, ranging from 0% to 20%, depending on your filing status and total taxable income for the year.
Are all bonuses taxable?
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 gain generated by the sale of a bond or bond fund before its maturity date is taxable, regardless of the type of bond.
taxable bonds
Interest income on taxable bonds is subject to federal, state (and local, if applicable) income taxes. Although the interest on these bonds is taxable, they often offer higher yields, albeit with greater risk.
Taxable bonds include:
- corporate bonds
- mortgage-backed securities
- Global Bond Funds
- Diversified Bond Funds
Savings bonds and treasury bonds, US Treasury bonds, bonds issued by the US Department of the Treasury are subject to federal income tax. However, they are generally free of state and local income taxes.
Are municipal bonds tax free?
Municipal bonds, also known as munis, are the main type of tax-exempt bond.
Municipalities are issued by states, counties, cities, and other government agencies to finance major capital projects, such as the construction of schools, hospitals, highways, and other public buildings.
Generally, interest income on municipal bonds is not subject to federal income tax. You may also be exempt from state or local income taxes if your state or hometown issues the bond. Interest income on municipal bonds issued by another state or city is taxable on your state or local income tax return.
How can I avoid paying taxes on bonds?
Here are some strategies to avoid, or at least reduce, the taxes you pay on bonds.
- Keep the bonus in a tax-advantaged account. When you invest in bonds inside a Roth IRA or Roth 401(k), the returns are tax-free as long as you follow the withdrawal rules. Bonus income and sales proceeds earned within a traditional IRA or 401(k) are tax-deferred, meaning you don’t pay taxes until you withdraw the money in retirement.
- Using savings bonds for educational purposes. Consider using Series EE or Series I savings bonds to save for education. When you redeem the bond, the interest paid is tax-free as long as you use the money to pay for qualified higher education expenses and meet other requirements.
- Hold bonds until maturity. Holding a bond to maturity, rather than selling it early on the secondary market, can help you avoid paying capital gains taxes. However, you still owe taxes on any taxable interest earned on the bond while you owned it.
Minimizing the tax consequences of bonds boils down to investing in tax-exempt bonds, like municipal bonds and US Treasuries, and using tax-advantaged accounts where your money can grow tax-free or tax-deferred .
If you invest in bonds outside of tax-advantaged accounts, you will receive a Form
1099
of the bank or brokerage house that has your investments around January 31 of each year. Save these forms, as you will need them to report bond interest and capital gains on your tax return. The IRS also gets a copy of those 1099s.
If you do not report any income, they will make sure to let you know.