How Investing in Bonds is Taxed

Bonds are a crucial part of investments plants for most business owners and they allow you the opportunity to diversify your portfolio. Have in mind that this also comes with a set of tax complications and as an owner you should be aware of them.

This is true even when you have a tax accountant to handle that part of the job for you. Bonds investing is popular because it’s safe and relatively predicable and because it’s profitable for the most part, but you should still be informed before getting into it.

Types of bonds

When it comes to how they are taxed, there are 3 types of bonds to be aware of. These are:

-US Treasury issues bonds. These aren’t taxed at all at a local or state level. They are only subjected to the federal income tax, and the allowances and rates related to it.

-Municipal bonds are bonds issued by local authorities. They work the other way around because they aren’t taxed at the federal level at all, only on the level that issued them in the first place.

-Corporate bonds have not tax free provisions. They are always taxed.

Zero coupons bonds

Zero coupon bonds are a specific type of bond that’s taxed in its own way. They are sold at a deep discount and there is no annual interest to pay on them. The full face value of the bonds is paid at maturity.

There’s however, a tax-related catch as is often the case. There’s an implied annual interest on the bonds calculated by the IRS and on it you pay your annual taxes as if you’ve made income on the interest regardless of the fact that you didn’t. You don’t pay any tax when the bond is mature and you actually make that income.  Essentially you’re taxed in advance.

Income tax

There are two main types of taxes to pay when investing in bonds. The first is income tax. This one is the simpler and it’s an annual tax on the income you’ve made from a bond during that particular year. The same rules apply to government and municipal bonds; the only difference is to whom the tax is paid.

The rates on this depend on your overall income since income is taxed progressively meaning that the more you earn the more taxes you pay. There are additional tax free allowances on bonds.

Capital gains

Another tax paid on bonds is the capital gains tax. The term basically means profit, or what you earn when you deduct all costs out of the sale or investments you’ve made. This is what happens when you buy a bond and sell it before maturity for more than you’ve paid for.

This tax isn’t progressive meaning that you pay the same percentage regardless of how much you earn. That’s a way for the government to support investing and putting money into markets.

Bond funds

Mutual funds that invest in bonds are usually seen as a safe source of income because they invest in a variety of bonds at once providing the diversification that’s so needed when it comes to investing of any kind. The income made this way is taxed after you pay for the service of running your mutual fund, which is done by a professional.

It’s also important to keep in mind that when you’re choosing a fund, the historical returns on that fund are expressed as a pre-taxed number meaning that you won’t make as much, because you also have to pay taxes on that amount.

Deferring taxes

As is the case with the taxes on other income, the tax on income made from bonds can be deferred by being held in an account that allows for such a thing. This is mostly the case with the accounts that you don’t use right away but hold on to for savings and retirement.

The most common of these are IRA funds or 401(k)s. This doesn’t mean that you won’t pay any taxes on these but that the taxes will be paid when you withdraw money from these accounts. Sometimes that’s only when you retire.

Conclusion

Investing in bonds is a common practice when you have money to invest and you want something that’s long term and relatively safe or at least as safe as these things can be. There are tax rules about these bonds that you should be aware of and they mostly depend on who has issued the bond.  The tax is paid on the level on which the bond was issued.

There are also two types of taxes to be aware of and it depends on how you earn from a bond. The taxes can be delated if you put the income in a 401(k).