If you are bondholder, the profit you earn from the sale of a bond or the interest on the bond attracts Federal Income Tax. Anything that generates income is taxable. However, not all bonds are taxed.

Investment and taxation go hand-in-hand. Bond holders may be aware of Form 1099 INT, in which an investor is required to enter the interest accrued from bonds.

Taxation rules for bond investors

Tax is one aspect that investors are unaware of in terms of what to report and what not. To understand the impact of tax on each type of bond, an investor needs to know the three types of bonds, namely, government, corporate, and municipal bonds.

Government bonds

These are debt securities issued by the government to aid government spending. Interest earned on treasury bills, notes, and bonds is taxable at the Federal level. Although a few government bonds are taxed, others are exempt from certain taxes. Bonds issued by the federal government are exempt from state and local taxes, and bonds issued by state or local governments are exempt of all taxes.

Corporate bonds

Bonds issued by a corporation and sold to investors are called corporate bonds. Any capital gains or losses incurred in the early sale of such bonds are taxed. Both federal and state income taxes apply to the interest earned on corporate bonds.

Municipal bonds

These bonds are mainly meant for high-net worth investors looking to reduce their taxable investment income. At the federal level, municipal bonds are exempted from tax. However, if a bond is issued from the same state or municipality where investor resides, the investor is exempt from state and local taxes as well. However, while filing taxes, the investor must report the income generated from such bonds.

There are other bonds as well, such as Zero-coupon bonds. Such bonds are issued at a deep rate of discount but do not pay any interest. Although no payments are made on zero-coupon bonds, the investor is nonetheless required to pay federal, state, and local income taxes on the amount of imputed interest received at bond maturity.

Saving bonds

Series EE bonds are taxed at the federal level but not at the state and the local levels. Series H and HH bonds are taxable every six months until maturity.

What is capital gain?

The profit or loss accrued on any bond or money instrument sold or issued in the secondary market is regarded as the capital gain on that investment. Capital gain tax is levied on government, corporate, and municipal bonds.

Before investing in bonds, investors must understand the nature of the bond and the term for which they want to hold the bond.