Your Guide to Bond Taxes

Bonds are a familiar part of most investment portfolios. Less familiar, perhaps, are how these investments are taxed. Spoiler alert: It can be more complex than you might expect. 

What follows is a basic overview of the tax rules for bonds that make regular interest payments and have maturities of over a year. The tax rules for more unique debt instruments, such as zero-coupon bonds or Separate Trading of Registered Interest and Principal of Securities (STRIPS), aren't covered here. 

We'll start with the information you'll need to determine how your bond proceeds will be taxed.

The tax rules will vary depending on who the issuer is. Bond issuers can generally be classified into one of three categories: 

• Corporate bonds, which are issued by private businesses. 
• Treasury bonds or notes, which are issued by the U.S. government.
• Municipal bonds (or munis), which are issued by a state or local government. 

Next, taxes will vary by the type of income you received. Bonds can generate income in three main ways: 

• Interest income, which is typically paid on a semiannual basis. Whether this income is taxable will depend on the issuer. Interest from corporate bonds is generally taxable at both the federal and state levels. Interest from Treasuries is generally taxable at the federal level, but not at the state level. Interest from munis is generally exempt from federal taxes, and if you live in the state where the bond was issued, the interest may also be exempt from state taxes. (However, not all municipal bonds qualify for these tax benefits, so be sure to check with your investment advisor before buying.)
• Capital gains, which are any profit you make from selling a bond before maturity. (Capital losses are also possible.) The tax rate charged will depend on how long you held the bond. If you've held it for less than a year, you'll be charged at your regular income tax rate. Bonds held for more than a year will be subject to potentially lower long-term capital gains rates. 
• The accretion of discounts, which refers to cases when you've acquired a bond at a discounted price. There are generally two ways to recognize these discounts: 
  • Over time: You can gradually recognize the difference between the purchase price and the bond's face value as ordinary income on your annual tax return. This is called accretion, which incrementally raises the cost basis of the bond so that it reaches face value at maturity. (Bonds with very small discounts—less than 0.025% of the bond's face value times the number of years to maturity—fall under the "de minimis" rule. More on that below.)
  • At maturity: You can recognize the full discount as ordinary income in the year the bond matures. However, you could end up facing an even bigger tax bill if the additional income bumps you into a higher tax bracket.

Comparing the bond's purchase price to its face value at maturity will help determine what rules apply. The tax treatment will vary depending on whether you bought the bond at par (that is, at its face value), at a premium (for more than the face value), or a discount (for less than face value).

With all that in mind, here are how the rules tend to work.

When the bond's purchase price is equal to its face value at maturity.

When the purchase price is more than the face value at maturity. 

When the purchase price is less than the face value at maturity. There are three types of discounted bonds, and each is treated slightly differently for tax purposes. 

This occurs when a bond is initially offered to the public at a price below its face value at maturity. The discounts on OID bonds generally must be recognized through accretion, and the gains are recognized as additional interest income at each coupon payment (the interest may not be taxable if the bond produces tax exempt income). 

This occurs when you a buy a bond on the secondary market at a discount after its original issue date.

This occurs when the discount is too small to matter, which is defined in the tax code as being: less than one-fourth of 1% (0.25%) of the stated redemption price at maturity, multiplied by the number of full years from the purchase date to maturity. If the de minimis rules apply, you won't need to worry about accretion and will be able to treat the discount as a capital gain rather than as ordinary interest income. OID municipal bonds are an exception to the de minimis rule because these bonds treat the entire discount as tax exempt if the bond is qualified.

When you buy a bond in the secondary market between coupon payments, a portion of the coupon payment and taxable income may belong to the seller. In this situation, the purchase price may also include past interest payments. The seller of the bond must report the accrued interest as ordinary interest income, while the buyer will reduce the cost basis of the bond to account for the interest that belongs to the seller.

Unless you're buying a bond at issue and holding it to maturity, the tax rules for bond proceeds can get complicated pretty quickly. That's why we recommend consulting with a tax professional and/or investment advisor for personalized guidance, if you have questions about your bond investments.