What are the Tax Implications of Owning Bonds?

What are the Tax Implications of Owning Bonds?

Some bonds receive preferential tax treatment. The interest you receive is fully taxable, unless the bonds are issued by municipalities, states, federal governments, or corporations with special tax-exempt statuses (such as school districts, infrastructure facilities, hospitals, and so on).

The first very general rule of thumb – if you reside in a certain municipality and buy bonds of that municipality, the interest is not taxable.

The second rule is very easy to remember: feds do not tax states, and states do not tax feds. In other words, if you own U.S. Treasuries, you will not pay the state tax on the interest that you earn. If you own state bonds, you will not pay federal taxes.

Depending on your income tax bracket, it might or might not be beneficial for you to buy tax exempt bonds. Careful calculations are required in each individual case, wherein an investor can weigh the yield of the muni bond against what’s called the tax-equivalent yield, or what yield a taxable instrument would have to pay to equal it post-taxes.

In general, municipal bonds are considered to be safer than corporate bonds. It is also obvious that you do not want to buy tax exempt bonds in your retirement accounts, since they are already tax exempt.

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How Does a 401(k) Compare With Other Retirement Plans?
What Types of Bonds Are There?