Bonds and Taxes

How to Benefit from Tax-Free Bond Income

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Bonds provide an important component of many financial plans, but, as with all investments, there's the sticky matter of taxes that you must address. And when it comes to taxes, bonds can be a little more complicated than some other investment options. 

Most investors buy bonds for two basic reasons: They're safe and they provide income. Bonds can provide some stability for your portfolio to counter the volatility of stocks while they still generate current or future income.

Investors don’t typically look to bonds to outperform stocks, although this happens from time to time. The main function of maintaining bonds in a portfolio is to achieve stability and income.

But then there's the tax issue. If you own stocks, you don’t pay taxes on their growth until you sell them, and then you're only taxed at the capital gains rate. Even dividends receive special tax treatment. But that's not the case with bonds. 

A Taxing Situation

Bonds can have immediate tax consequences because you typically receive income from them twice a year. Here’s how the tax situation breaks down per bond type:

  • U.S. Treasury issues: These notes and bills generate federal income tax liability, but no state or local income taxes.
  • Municipal Bonds: Municipals, sometimes known as munis, are tax-free at the federal level. If you buy them in the state where you live, they can be free of state and local taxes as well. These are sometimes called “triple free" for that reason. 
  • Corporate Bonds: Corporate bonds have no tax-free provisions.
  • Zero Coupon Bonds: Zero coupon bonds are sold at a deep discount and pay no annual interest. The full face value is paid at maturity. But there's a catch. IRS computes the "implied" annual interest on the bond and you're liable for that amount even though you don’t actually receive it until the bond matures. Yes, you read that correctly. You're taxed now on income you haven't received yet and might not receive for years to come. 

    As you can see, municipal bonds are obviously the best tax deal. The yield on munis reflects this benefit.

    Do the Math

    There's a quick way to look at how a municipal bond compares with a stock on an after-tax basis—which, after all, is the only basis that matters. You can compute the taxable equivalent of a municipal bond’s return using this formula:

    Figure your marginal tax rate, which is what you'll pay on the next dollar of income you earn. Subtract it from the number 1. Then divide a muni yield by the result to get the taxable equivalent. For example, if you're going to be in the 28 percent tax bracket and you're considering a muni with a yield of 2.8 percent, the calculation would look like this:

    0.028 / (1 – 0.28) = 3.89%

    This muni would give you the same effective return as a taxable security that pays about 3.89 percent. If you add in state and local taxes, it could push your taxable equivalent return even higher.

    Conclusion

    Of course, stocks have always out performed bonds over the long term, but if you're looking for relatively secure income at a reasonable return, municipal bonds are worth a look for their tax benefits.

    Note: Always consult with a financial professional for the most up-to-date information and trends. This article is not investment advice and it is not intended as investment advice.