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:
- Elect to recognize a portion of the discount each year as taxable income (just as you would with an OID).
- 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 |
Source:
Charles Schwab Investment Advisory, Inc.
For illustrative purposes only. The example assumes the taxable income from the discount and accretion are recognized using the ratable accrual method, a formula for determining taxes on interest income in a given period.
- 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.
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