Smart Bond Investing—Buying and Selling Bonds

Bonds and Taxes

 

As with buying and selling stocks, there are tax consequences associated with buying and selling bonds. Interest Income

 

Interest Income

 

Whether or not you will need to pay taxes on a bond's interest income (coupons) or a bond fund's dividends depends on the entity that issued the bond.

 

  • Corporate and Mortgaged-Backed Bonds—The interest you get from corporate and mortgage backed bonds typically is subject to federal and state income tax.

     

  • Treasuries and Other Federal Government Bonds—The interest you earn on Treasuries and agency bonds backed by the "full faith and credit" of the U.S. government is subject to federal income tax, but not state income tax. This does not include bonds in which the U.S. government only provides a guarantee such as with Ginnie Maes.

     

  • Municipal Bonds—Municipal bonds are generally exempt from federal income tax. If the municipal bond was issued by your state or local government, the interest on the bond is usually exempt from state and local taxes, as well. However, if the bond was issued by a state or local government outside of the state in which you reside, the interest from the bond is usually subject to state income tax. Bonds issued by a U.S. Territory, such as Puerto Rico or Guam, however, are exempt from federal, state and local taxes in all 50 states.

 

As of January 1, 2013, the tax code imposes a Net Investment Income Tax of 3.8 percent on investors who meet certain income thresholds and other criteria. To learn more about the tax, who it applies to and how you calculate net investment income, be sure to talk with your tax professional or read the IRS's Net Investment Income Tax FAQs.

 

Gains

 

When you purchase an individual bond at face value and hold it to maturity, there is no capital gain to be taxed. Of course, if you sell the bond for a profit before it matures, you'll likely generate a taxable gain, even if it's a tax-exempt bond. If you owned the bond for more than a year, your gain is taxed at the long-term capital gain rate, which can be 20 percent for people in the highest tax bracket or 0 percent for those in the lowest two tax brackets.  If you owned the bond for one year or less, you are taxed at the short-term rate, which can be as high as 43.4 percent for those in the highest tax bracket.

 

With a bond fund, you are unlikely to sell at the exact share price at which you bought, which means you incur a capital gain or loss. In addition, mutual fund managers buy and sell securities all year long, incurring capital gains and losses. If the gains are more than the losses, shareholders will receive a capital gain disbursement at the end of the year.

 

Remember: the tax rules that apply to bonds are complicated. Before investing, you may want to check with your tax advisor about the tax consequences of investing in individual bonds or bond funds. For additional information on the tax treatment of investment income, see IRS Publication 550 as well as the IRS's Net Investment Income Tax FAQs.
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