Taxes On Bonds - How Does That Work?

Nowadays, bonds are one of the safest investment vehicles mostly because of their fixed maturity dates and fixed interest rates. However, it must be emphasized that taxes on bonds must be considered before investing in these debt securities obviously because the taxman cometh. You should remember that bonds face taxes upon income, which is usually twice a year and which is in contrast with stocks where taxes are levied only upon their sale.

Taxes On Bonds Depends on the Bond Type

Yes, the myth about government-issued bonds being tax-free is true although it must be emphasized that there are validating circumstances. Let's call them tax incentives, instead, which the issuing federal, state and local governments have the right to offer as a way of attracting more bond buyers. Here's a simple breakdown of these taxes on bonds issued by the government:

• US Treasury bond issues like notes, bills and bonds generate federal income tax liability although these are not subject to local and state income taxes.
• Municipal bonds are free from federal income tax liability. If you purchase these bonds from the state where you live in, you can also escape the clutches of the state and local taxmen. Talk about "triple free" privileges on bonds.

In contrast, corporate bonds are not - emphasis on not - exempt from taxes. You have to pay the taxes due as the income from interests come into your account, the computation of which is briefly discussed in the next section. The interest rates may be higher on corporate bonds in comparison with government bonds but their taxes must be considered.

And then there is the zero coupon bonds, which are sold with substantial discounts and pay no annual interest with their full face value paid at maturity. The taxes on bonds are computed based on the implied annual interest even when there was no actual receipt of the income.

Taxes On Bonds - Still Have To Do the Tax Math

The best way to know the exact amount for taxes on whatever bonds are earning in your investment portfolio is to contact your accountant. With the maze of tax guidelines to navigate, an ordinary bondholder will certainly be confused about what bond is taxable and by how much percent.

Still, you will be able to understand the taxes on bonds for municipal issues by asking the following questions:

• What's your federal tax bracket? The answer to this question will determine the tax rate to be applied on your bond income.

• What's your reciprocal tax bracket? Basically, you will deduct your tax bracket from 100 to arrive at your reciprocal bracket. For example, if you belong to the 33% bracket, your reciprocal bracket is 66%.

• What's your municipal bonds' tipping point? This is the part where you decide whether municipal bonds are for you or not. Let's say that the yield for a top-rated, tax-exempt, 10-year municipal bond is 3.84%. Divide the yield by the reciprocal rate to get the tax-equivalent yield: 3.84%/66% = 5.81%. This means that a taxable bond with a yield of 5.81% is preferable to a 3.84% tax-exempt bond. Of course, the assumption here is that all other factors like maturity and level of risks are equal.

If these taxes on bonds seem complicated, your best option is to consult with your accountant. Too many self-advised "accountants" make the taxman unhappy and that is something you want to avoid.