What Is a Taxable Bond?
A taxable bond is a debt security (i.e., a bond) whose return to the investor is subject to taxes at the local, state, or federal level, or some combination thereof. An investor trying to decide whether to invest in a taxable bond or tax-exempt bond should consider what they will have left in income after taxes are taken.
Key Takeaways
- Taxable bonds are subject to taxation from the bondholder.
- Most bonds are taxable. Generally, only bonds issued by local and state governments (i.e., municipal bonds) are tax-exempt and even then special rules may apply.
- You must pay tax on both interest payments and on capital gains if you redeem the bond before its maturity date.
How Taxable Bonds Work
All corporate bonds and some government bonds are taxable bonds. For example, Treasury securities are taxed at the federal level but may be tax-exempt from local and state taxes.
As stated above, the majority of bonds issued are taxable bonds meaning their interest payments to investors are taxable at either the federal and/or state level. Fixed or variable interest on a bond is income paid to bondholders as compensation for lending the issuer funds for a fixed period of time. Those payments are called "coupon payments," and they are usually made annually, semi-annually, or quarterly, depending on the terms and conditions highlighted in the bond purchase agreement.
At the end of the year, people who have invested in taxable bonds and have received interest income are required to include the amount of interest received on the bonds on their tax filings to their local and state governments and to the federal government. If the bonds were issued at a discount and held until maturity and then were redeemed for face value, the bondholder would be liable for taxes on the spread.
Municipal Bonds and Tax Exemption
Municipal bonds, on the other hand, are not taxed at the federal level and may also be exempt from state taxes if the bondholder resides in the state where the bonds are issued.
Some municipal governments issue taxable bonds to finance projects that do not benefit the public at large. Interest from municipal bonds issued to finance projects with no obvious public benefit is taxable since the federal government will not subsidize the financing of these projects. Since income from such bonds is taxable in the hands of the investor, taxable municipal bonds offer risk-adjusted yields that are comparable to those available from other taxable entities such as corporate bonds and other government agency bonds.
For example, some universities, through municipal authorities, may issue taxable bonds to finance the building of new facilities or expansion of some department wings. These bonds, however, return the market rate as opposed to the lower return rate offered by tax-free bonds.
Examples of Taxable Bonds
Consider a zero-coupon bond and Treasury bill, which do not pay interest for the duration of the bond’s life. Instead, they are offered at discounts and redeemed at par value on the maturity date. For example, an investor may purchase a bond for $950 and receives $1,000 face value at maturity. The $50 difference represents the return on the investment and is taxed as interest income.
Even though the bondholder does not receive interest income per se, the discount is considered imputed interest by the Internal Revenue Service (IRS) and must be reported at the end of the tax year. However, if the discount bond is sold before maturity, a capital gain or loss will ensue which must be reported in order to be taxed accordingly.
FAQs
Examples of Taxable Bonds
Consider a zero-coupon bond and Treasury bill, which do not pay interest for the duration of the bond's life. Instead, they are offered at discounts and redeemed at par value on the maturity date. For example, an investor may purchase a bond for $950 and receives $1,000 face value at maturity.
How do taxable bonds work? ›
The income from taxable bond funds is generally taxed at the federal and state level at ordinary income tax rates in the year it was earned. Funds that exclusively hold U.S. Treasury bonds may be exempt from state taxes.
What is the meaning of tax bond? ›
For anyone asking themselves "What is a tax bond?," it's a financial guarantee bond that offers security for a business that will automatically cover all of the various sales taxes that are owed on a state and federal level.
What and how do bonds work? ›
Bonds are an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.
How do you calculate taxable bonds? ›
How Tax Equivalent Yields Are Calculated. The Tax-Equivalent Yield Calculator uses the following formulas to calculate tax-equivalent yields: Out-of-State Municipal Bond Yield = In-State Muni Bond Yield / (1 – Out-of-State Muni Bond Tax Rate) Treasury Bond Yield = In-State Muni Bond Yield / (1 – Treasury Bond Tax Rate)
What is an example of a bond income? ›
For a $1,000 par, 10% annual coupon bond, the issuer will pay the bondholder $100 each year.5 If prevailing market interest rates are also 10% at the time that this bond is issued, an investor would be indifferent to investing in the corporate bond or the government bond since both would return $100.
Do I have to pay taxes on my bonds? ›
The interest you earn on corporate bonds is generally always taxable. Most all interest income earned on municipal bonds is exempt from federal income taxes. When you buy muni bonds issued by the state where you file state taxes, the interest you earn is usually also exempt from state income taxes.
How do I bonds work for taxes? ›
I bonds also have important tax advantages for owners. For example, interest earned on I bonds is exempt from state and local taxation. Also, owners can defer federal income tax on the accrued interest for up to 30 years.
Do bonds go on tax return? ›
In general, you must report the interest in income in the taxable year in which you redeemed the bonds to the extent you did not include the interest in income in a prior taxable year.
How do tax credit bonds work? ›
Tax Credit Bonds provide periodic tax credits to the holders of the bonds. Direct Pay Bonds are a type of tax credit bond for which the issuer has elected to receive direct payments from the federal government instead of the tax credits that would otherwise be allowed to holders of the bonds.
For example, if a company wants to build a new plant, it may issue bonds and pay a stated rate of interest to investors until the bond matures. The company also repays the original principal. Unlike buying stock in a company, buying a corporate bond does not give you ownership in the company.
How do bonds pay you? ›
In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value. The company pays the interest at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan.
How do bond funds work for beginners? ›
Bond funds allow you to buy or sell your fund shares each day. In addition, bond funds allow you to automatically reinvest income dividends and to make additional investments at any time. Most bond funds pay regular monthly income, although the amount may vary with market conditions.
What type of bonds are not taxable? ›
Interest from corporate bonds and U.S. Treasury bonds interest is typically taxable at the federal level. U.S. Treasuries are exempt from state and local income taxes. Most interest income earned on municipal bonds is exempt from federal income taxes.
What is the difference between a taxable bond and a municipal bond? ›
Tax Liability: Unlike municipal bonds, the interest earned on taxable bonds is subject to federal, and possibly state and local, income taxes. This reduces the net income for investors, particularly those in higher tax brackets.
What is an example of a tax-exempt bond? ›
Examples of Exempt Facility Revenue Bonds
Typical examples are terminals, hangars, aircraft repair facilities, freight forwarding/warehousing facilities, etc. If tax-exempt bonds are to be used to finance such facilities, certain limitations and conditions exist.
