When Should You Pay Taxes on Discount Bonds?

March 8, 2024
Tax-sensitive bond investors need to consider the tax ramifications when purchasing discount bonds.

Investors who buy bonds for less than their face value do so in part because, barring default, they'll receive the bond's full value at maturity, which increases the total income from the bond and helps compete with higher-yielding bonds. However, investors should be mindful of the potential income taxes they'll owe on the discount—especially when purchasing municipal bonds, whose discounts on the secondary market are taxable even if the income they generate is not.

"Taxes should never be your first investment consideration, but they should be a consideration," explains Hayden Adams, CPA, CFP®, director of tax and wealth management at the Schwab Center for Financial Research. "Where discount bonds are concerned, you'll need to consider not only what taxes you could owe but also when to pay them."

  • For newly issued taxable bonds purchased at an original issue discount (OID): You'll generally be required to recognize a portion of the discount each year as taxable income (known as accretion)—which also increases the cost basis of the bond—until maturity, when the cost basis equals the bond's face value. (Qualified OID municipal bonds are exempt from tax on the discount.)
  • For discount bonds purchased in the secondary market: You have two options:
    1. Elect to recognize a portion of the discount each year as taxable income (just as you would with an OID). 
    2. Elect to recognize the full discount as interest income in the year the bond matures. "Although if you recognize the full discount at maturity you could end up facing an even bigger tax bill if the additional income bumps you into a higher tax bracket," Hayden says.

Timing is everything

Consider an investor who purchases 100 taxable bonds with a five-year maturity for $800 each ($80,000 total purchase price) and a $1,000 face value ($100,000 received at maturity). Realizing the entire value of the discount in the year of maturity could add significantly to their taxable income.

Over time (accretion)

Year Realized interest income from discount Cost basis of bonds
1 $4,000 $84,000
2 $4,000 $88,000
3 $4,000 $92,000 
4 $4,000 $96,000
5 $4,000 $100,000

At maturity

Year Realized interest income from discount Cost basis of bonds
1 $0 $80,000
2 $0 $80,000
3 $0 $80,000
4 $0 $80,000
5 $20,000 $100,000
  • For bonds with very small discounts: If the discount is less than 0.25% of the bond's face value times the number of years to maturity, the discount is taxed as a capital gain in the year the bond matures.

"Paying taxes on the discount over time can be advantageous if you're expecting to be in a higher tax bracket in the future," Hayden says. "Whereas those anticipating a lower tax bracket may wish to wait until maturity."

Either way, it's wise to work with a wealth advisor or other professional who can help you devise a comprehensive tax plan.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk, including loss of principal.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Charles Schwab & Co., Inc. does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

Charles Schwab Investment Advisory, Inc. ("CSIA") is an affiliate of Charles Schwab & Co., Inc. ("Schwab").

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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