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Andrew Bloomenthal has 20+ years of editorial experience as a financial journalist and as a financial services marketing writer.
Updated July 21, 2024 Reviewed by Reviewed by Lea D. UraduLea Uradu, J.D. is a Maryland State Registered Tax Preparer, State Certified Notary Public, Certified VITA Tax Preparer, IRS Annual Filing Season Program Participant, and Tax Writer.
Fact checked by Fact checked by Vikki VelasquezVikki Velasquez is a researcher and writer who has managed, coordinated, and directed various community and nonprofit organizations. She has conducted in-depth research on social and economic issues and has also revised and edited educational materials for the Greater Richmond area.
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.
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.
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 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.
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.
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.
When investing through your tax-deferred account (such as an individual retirement account (IRA) or 401(k)), buying corporate bonds with high yields may give you a return advantage over municipal bonds in a taxable account, despite the tax benefits that municipal bonds offer.
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.
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.
While investors will pay federal taxes on the interest income from government bonds, they won't owe state and local taxes. Investors in municipal bonds can avoid taxes altogether if they live in the area where the muni is issued.
A corporate bond is a type of debt security issued by a corporation and sold to investors to raise capital. In return for the bond purchase, the investor is paid interest at either a fixed or variable interest rate.
Bond income is reported alongside any other interest income earned during the year, which may include interest income from savings accounts, certificates of deposit (CDs), and similar products.
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.
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Unrecaptured Section 1250 gain relates to an IRS tax rule directing that depreciation be recaptured when a gain is realized on the sale of depreciable real estate.
A deferred tax liability is a line item on a balance sheet that indicates that taxes in a certain amount have not been paid but are due in the future.
Use tax is a type of sales tax applied to purchases that will be used in one’s state of residence and on which no tax was collected in the state of purchase.
A widow(er)'s exemption is one of several forms of state or federal tax relief available to a surviving spouse in the period following their spouse's death.
A private letter ruling is an IRS interpretation of rules and their application in response to a particular taxpayer's complex set of circumstances.
The phrase taxation without representation describes a situation when a population is required by law to pay taxes without receiving government representation in return.
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