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How Are Bonds Taxed

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 12/31/2009

Bonds are an important part of most investor’s portfolios. However, some bonds can cause tax problems, while others provide tax-free interest income. Understanding how both government bonds and corporate bonds are taxed is key.

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    Taxable Bonds

    Corporations issue bonds to finance their operations. Whether issued to finance day-to-day expenses, or sold to fund long-term strategic acquisitions or other objectives, corporate bonds typically pay a higher interest rate than similar risk profile Treasuries or Municipal Bonds. One reason for this higher interest rate payment is that the interest from corporate bonds is fully taxable at both the state and Federal level, which is why corporate bonds are often referred to as taxable bonds.

    Comparing corporate bonds to government bonds is often accomplished using the tax-equivalent yield, which states the interest rate as adjusted for the cost of taxes on the interest payments.

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    Tax-Free Bonds

    Municipal bonds, or Muni bonds, are often referred to as tax-free municipal bonds. However, this isn’t always the case.

    The United States Constitution prohibits different the levels of government from taxing each other. Thus, the Federal Government cannot levy taxes on State government, and vice versa. What that means is that all bonds issued by state or local governments, commonly known as Muni bonds, are exempt from Federal Income taxes. In order to be truly tax-free bonds, however, they must also be exempt from local income taxes as well. Most state governments exempt the interest payments from their own muni bonds from state taxes as a matter of convention. However, this exemption does not cross state lines. Thus, only municipal bonds held by residents of the states that issued them are fully tax-exempt.

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    U.S. Treasury Bonds, Notes, and T-Bills

    Debt securities issued by the Federal Government are likewise exempted from taxation at the state level. Thus, the owner of a Treasury Bond need not pay taxes on its interest to the state in which they reside. This advantage is greater for investors living in states with higher income taxes such as California, and offers no advantage in states where there is no income tax, such as Texas.

    However, U.S. government securities are taxable at the Federal level. That means that interest payments from a T-Note are taxable for Federal Income Tax purposes. However, certain government debt interest is tax deferred, or in the case of U.S. Savings Bonds may be used tax-free for certain purposes.

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    Savings Bond Tax Advantages

    U.S. Savings Bonds are exempt from all state and local income taxes. However, the interest paid on savings bonds is not tax-free from Federal Income taxes. The difficulty that arises is that savings bonds do not make regular interest payments, but rather accumulate their value within the bond itself.

    This is one reason why savings bond interest is tax deferred, meaning that taxes are not due on the interest until the savings bond is redeemed. Redeeming savings bonds for specific purposes also yields tax-free interest payments. The most commonly known of these reasons is that savings bonds are tax-free to pay for college for most students and parents.






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