For new investors, it can be hard to determine your tax liabilities from your investments. Reading up on the available types of bonds and their tax consequences can help you make informed decisions on your investments and how they are taxed.
When people talk about investing, the phrase "stocks and bonds" tends to come up a lot. But why exactly should you invest in either of these options? Understanding the basics of investing in bonds is an important part of getting started as an investor and choosing the best investments for yourself.
Here's a guide to help you determine why you might invest in bonds, the types of bonds available, and what else you need to know about this crucial piece of an investment portfolio.
What are investment bonds?
When you purchase a bond, you're essentially lending money to a company or government. Companies and governments issue bonds to raise money for business operations, expansions or large infrastructure projects.
Over the bond's term, you earn interest on the amount of the bond at an agreed-upon rate. This rate is typically fixed for the life of the bond it can change for some bonds. That fixed, agreed-upon interest rate is why bonds are also typically known as "fixed income" investments — because you get back a fixed amount. On most bonds’ maturity date, you receive back the bond's par or face value.
When a bond is first issued, the price you pay for the bond is usually its par value. For example, you might purchase a bond with a par value of $1,000 at a 4% interest rate (also known as its coupon rate).
After a bond is issued, investors can also sell it before its maturity date. At this point, the bond may sell at a "premium" or "discount." When an existing bond offers a higher coupon rate than the rate currently offered on new bonds, it typically trades above (premium) its par value on the secondary market and becomes a premium bond.
When a bond offers a lower coupon rate than the rate currently offered on new bonds, it typically trades below (discount) its par value and becomes a discount bond.
Why invest in bonds?
Investing in bonds offers several advantages over other investments. First, they're a relatively safe investment compared to stocks because their value doesn't usually fluctuate as much as stock prices do. This is why they're a popular option for diversifying your investment portfolio. While bonds typically don't generate the big returns that investing in stocks may deliver, they can provide stability for your investment portfolio. Having a mix of both stocks and bonds can reduce your financial risk when the stock market fluctuates.
Another advantage of investing in bonds is their predictable income stream. Because bonds pay a fixed amount of interest (typically paid twice per year), you can typically count on that income. Depending on the type of bond you invest in, that income may even be tax-free.
Of course, like other types of investments, there is some element of risk when investing in bonds. While it's uncommon, the bond issuer can default on its bond obligations. When that happens, you can lose out on interest payments, not get your initial investment back, or both.
Types of investment bonds
Bonds come in a variety of forms. Here are some of the most common categories.
- Corporate bonds. Companies, including well-known names like Apple, Walmart, ExxonMobil, and Pfizer, issue corporate bonds. Corporate bonds tend to offer higher interest rates than other types of bonds, but the risk of default is higher. To reduce the risk of losing money due to default, check out the credit ratings on corporate bonds issued by agencies like Standard & Poor's and Moody's. Corporate bonds that have a lower credit rating are known as high-yield or junk bonds. Because the risk of issuer default is higher, the interest rate (or yield) is usually higher.
- Municipal bonds. Municipal bonds, also known as "muni bonds," are bonds issued by states, counties, cities, and other state and local government agencies. Municipal bonds are usually issued to pay for large, expensive capital projects, such as building hospitals, schools, airports, bridges, highways, water treatment facilities, or power plants.
- U.S. Treasury bonds. The U.S. government issues these bonds, which are generally considered to be the safest investments. Because the default risk is lower than that of corporate bonds, they usually pay a lower interest rate. U.S. Treasury bonds are divided into three categories, depending on their maturity. T-Bills come in four-week, eight-week, 13-week, 26-week, and 52-week maturities. T-Notes have maturities of two, three, five, seven, or 10 years. T-Bonds mature in 30 years.
To invest in corporate and municipal bonds, you typically must use a broker. You can buy treasury bonds directly from the U.S. government through TreasuryDirect without going through a broker.
For some investors, selecting individual investment bonds can be intimidating. That's why many people choose to invest in bond mutual funds rather than individual bonds. Bond mutual funds hold a large number of bonds with a variety of maturity dates, interest rates, and credit ratings. This can make it much easier to diversify your bond portfolio because the fund invests in the bonds and you have an interest in a small amount of each bond within the fund rather than investing a large sum into a single bond.
How are bonds taxed?
Bonds are typically taxed in two ways: when you earn interest on the bond and any capital gain on the sale.
Tax on interest
When you earn interest, the IRS expects you to report that income on your tax return. Whether or not that income is taxable depends on the type of bond you invest in.
- The interest you earn on corporate bonds is generally always taxable.
- Most all interest income earned on municipal bonds is exempt from federal income taxes. When you buy muni bonds issued by the state where you file state taxes, the interest you earn is usually also exempt from state income taxes. If you buy muni bonds issued by another state, you'll still typically avoid federal taxes, but you'll likely be subject to state (and possibly local) income taxes.
- U.S. Treasuries are exempt from state and local income taxes but are taxable at the federal level.
After the end of the tax year, your financial institution or the bond issuer should send you a Form 1099-INT reporting all the taxable and tax-exempt interest you received during the year. Typically, interest from corporate bonds will be in Box 1, interest from U.S. Treasuries will be in Box 3, and tax-exempt interest from muni bonds will be in Box 8.
Even if you don't have to pay income tax on the interest, you still need to include it on your tax return. That's because, while some bond interest is tax-exempt, the IRS still includes it in some calculations. Perhaps most notably, if you receive Social Security income, tax-exempt municipal bond interest can impact how your Social Security benefits are taxed.
The IRS includes muni bond interest in your modified adjusted gross income. If half of your Social Security benefit plus other income, including tax-exempt muni bond interest, is between $32,000 and $44,000 for a joint tax return ($25,000 to $34,000 for single filers), up to 50% of your Social Security benefits may be taxable. Above those thresholds, up to 85% of your benefits could be taxed.
Tax on capital gains
If you buy a bond when it is issued and hold it until maturity, you generally won't have a capital gain or loss. However, if you sell the bond before its maturity date for more than you paid for it, you'll typically have a capital gain. If you sell it for less than you paid for it, you'll usually have a capital loss.
After the end of the tax year, your financial institution will send you a Form 1099-B reporting any bond sales that took place during the year.
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