The answer to this question is a bit complicated, and not what most people think.
Most people have heard that bonds are taxable, but they don’t know why or how exactly it works. It’s confusing enough that the IRS has an entire section devoted to answering the question “Are Bonds Taxable?” on their website.
Are Bonds Taxable? Yes, bonds are taxable. Municipal Bonds, for example, are not taxable at the federal level but may be taxable at the state and local levels. Corporate Bonds are taxable at both the federal and state levels.
We’ll do our best to explain and help you understand what you need to know about taxes on bonds. There are three types of bond income which we will discuss below.
Are Bonds Taxable?
Bonds are typically taxed at the federal level. This means that if you were to purchase a $1,000 bond (through your broker or through TreasuryDirect) you would not owe taxes on the interest it accrued during the year. However, if you were to cash out that bond before it matured, you would owe taxes on the gains ( the difference between what you paid for it – principal or par value, and what you sold it for – the amount of money that you get back).
The Internal Revenue Service (IRS) considers interest income on bonds to be taxable. There are three types of bond income which we will discuss below.
Municipal Bonds, for example, are not taxable at the federal level but may be taxable at the state and local levels. Corporate Bonds are taxable at both the federal and state levels.
- The bondholder is taxed on the taxable bonds.
- All bonds are taxable. Only municipal bonds issued by local and state governments are tax-exempt, and even then there are limits.
- If you redeem a bond before its maturity date, you must pay tax on both interest payments and capital gains.
Every year, bondholders fill out IRS Form 1099-INT to report their yearly taxable interest income.
At first view, this document provides simple guidelines for reporting tax on income earned at the specified rates of interest, but there are frequently intricate elements to consider.
People who have invested in taxable bonds and obtained interest income are required to submit tax papers to their local, state, and federal governments at the conclusion of the year.
Interest on investments, including interest earned through the purchase of bonds, is considered taxable income.
Bonds are considered low-risk investments because they pay a fixed rate of interest that remains constant for the life of the bond. Because bonds are not subject to annual taxation on capital gains, bondholders generally receive all of their earnings through interest payments.
However, if you redeem a bond before its maturity date, you must pay tax on both interest payments and capital gains. There is no federal tax on any of the initial $1,000 in your savings account because Americans are immune to taxation on sums less than $10,000 deposited into traditional banking accounts.
Calculating Taxes on Bonds
On the surface, calculating taxes on bonds seems like a simple task. It’s not.
The problem is that there are many different kinds of bonds and each one has its own tax implications. There are municipal bonds, corporate bonds, zero-coupon bonds, and more. Each type of bond has different rules for taxation which makes it difficult to calculate your taxes accurately without using expensive software or hiring an accountant to do it for you.
This guide will teach you how to easily calculate the correct tax amount on any kind of bond in seconds so that you can get back to doing what really matters – investing!
- Go to the Treasury Direct website and open the Savings Bond Calculator.
- Determine your filing status and taxable income based on your prior year’s tax return.
- Refer to the Tax Rate Schedule in the 1040 instructions. Locate your filing status on the appropriate tax rate schedule, then look for the line with your taxable income.
- Multiply the interest you have earned on the bond by your federal tax rate. For example, if you have earned $1500 in interest and your tax rate is 28% then the tax on your bond is going to be multiplied by 1500 with .28
How to File Bond Income on Your Federal Taxes
You can file tax on bonds income by submitting a 1099-INT form to IRS. In the case of a mutual fund, you have no say whether or not you get a 1099-DIV, the custodian will automatically send one to you if your share value has changed during a given year.
Also, when giving a bond as a gift, you must report the interest as income on your annual tax return.
In case of a bond being repurchased from the primary shareholder, you have to pay taxes for its redemption if it has been less than a year since you bought it. In addition to that, there will be no tax associated with redeeming a bond that is more than a year old if it is listed as taxable income on your annual tax return.
Finally, you will be taxed only by the gain that you have not excluded from taxation if you redeem the bond before five years. If you hold it for more than five years then there won’t be any interest amount related to the redemption of the bond.
State Taxes on Bonds
Only the federal government taxes bonds. Each state has a separate statute for the taxation of its resident taxpayers. There is no standardization between states, and each one can tax residents on interest earned from bonds at their own discretion. Some may apply a flat rate, some may use progressive income tax rates, and others might not tax them at all.
Taxation of Federal Government Bonds
State and local taxes are generally not applicable to income derived from federal government bond sales, such as Treasury securities.
Taxation of Municipal Bonds
The interest from municipal bonds, or munis, issued by a state, city, and local government is generally exempt from federal taxes.
In most states, municipal bond interest is also tax-free. In some cases, this may not be the case. For example:
- In some states, interest on government bonds is taxed.
- In some states, no interest is taxed on municipal bonds issued by any state.
- A state that usually taxes interest on municipal bonds may exempt specific bonds from taxation when it issues them.
Municipal bonds may also be exempt from local taxes in certain jurisdictions, depending on the regulations. For further information regarding state rules, see a tax counselor.
Conclusion
If you want to be the best investor possible, it’s important that you understand how your bond investments may impact your tax rate. Municipal bonds can have significant federal income tax implications, so make sure you do some research before deciding which one is right for your portfolio.