As with buying and selling stocks, there are tax consequences associated with buying and selling bonds.
Interest Income
Whether or not you will need to pay taxes on a bond's interest income (coupons) or a bond fund's dividends depends on the entity that issued the bond.
- Corporate and Mortgaged-Backed Bonds—The interest you get from corporate and mortgage backed bonds typically is subject to federal and state income tax.
- Treasuries and Other Federal Government Bonds—The interest you earn on Treasuries and agency bonds backed by the "full faith and credit" of the U.S. government is subject to federal income tax, but not state income tax. This does not include bonds in which the U.S. government only provides a guarantee such as with Ginnie Maes.
- Municipal Bonds—Municipal bonds are generally exempt from federal income tax. If the municipal bond was issued by your state or local government, the interest on the bond is usually exempt from state and local taxes, as well. However, if the bond was issued by a state or local government outside of the state in which you reside, the interest from the bond is usually subject to state income tax. Bonds issued by a U.S. Territory, such as Puerto Rico or Guam, however, are exempt from federal, state, and local taxes in all 50 states.
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Understanding the Act
The 2003 tax reduction bill, formally known as the Jobs and Growth Tax Relief Reconciliation Act, lowered taxes on stock dividends and long-term capital gains on securities held in taxable accounts to a maximum of 15%. However, income from bond interest is NOT included in this tax break.
Note: Some bond mutual funds refer to their taxable income distributions as "dividends," but these are not stock dividends, and are not entitled to the lower 15% rate.
Be wary of making investment decisions based on current tax rates, especially since the lower dividend and long-term capital gains tax rates are scheduled to end or "sunset" after 2010.
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Gains
When you purchase an individual bond at face value and hold it to maturity, there is no capital gain to be taxed. Of course, if you sell the bond for a profit before it matures, you'll likely generate a taxable gain, even if it's a tax-exempt bond. If you owned the bond for more than a year, your gain is taxed at the long-term capital gain rate, which is currently, at most, 15%. If you owned the bond for one year or less, you are taxed at the short-term rate, which can be as high as 35%.
With a bond fund, you are unlikely to sell at the exact share price at which you bought, which means you incur a capital gain or loss. In addition, mutual fund managers buy and sell securities all year long, incurring capital gains and losses. If the gains are more than the losses, shareholders will receive a capital gain disbursement at the end of the year.
Remember—the tax rules that apply to bonds are complicated. Before investing, you may want to check with your tax advisor about the tax consequences of investing in individual bonds or bond funds.
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