Tax Rules for Bond Investors

Those who invest in bonds can owe taxes on interest income and capital gains. Each year, bondholders receive IRS Form 1099-INT (or Form 1099-OID) from entities that paid them interest on the bonds in which they invested. Investors use this form to help them report their annual taxable interest income when filing tax returns.

Since tax rules for bond investors can vary depending on whether you invested in government, corporate, or municipal bonds, it's important to understand the rules that may apply to you, based on your holdings.

Government Bonds

The interest from Treasury bills, notes, and bonds is taxable at the federal level but not at the state and local levels. In addition, 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 bond 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. U.S. government Series EE savings bonds are free from state and local tax, and the federal taxes on interest income may be deferred until maturity. The Series I savings bond is also free from state and local tax.

The interest from Series EE and I bonds issued after 1989 may also be exempt from federal taxes if the proceeds are used to pay higher education expenses.

Municipal Bonds

Often purchased by high-income investors, municipal bonds can mean tax-free 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 and later sell them for a capital gain may be taxed at ordinary long- or short-term capital gains rates.

Corporate Bonds

Interest earned from corporate bonds is fully taxable at all levels. Because these bonds typically have the greatest risk of default, they pay the highest interest rates of 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 income each year.

Capital Gains

Capital gains are different from interest income paid by bonds. Regardless of the type of bond, any debt issue purchased and sold in the secondary market will post a capital gain (or loss). This includes government and municipal issues, as well as corporate debt. Gains and losses on bond transactions are taxed the same way that other securities, such as stocks or mutual funds, are taxed. That is, at the appropriate capital gains tax rate.

Amortization of Bond Premium

The amortizable bond premium refers to the price paid for a bond above its face value. The premium paid represents part of the cost basis of 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.

The Bottom Line

The tax implications for investors in fixed income can vary, according to the type of security that they purchase. 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 with tax planning strategies that may reduce what they owe.