A taxable bond is a type of debt security (like a bond) where the returns you get as an investor are taxed at the local, state, or federal level, or a mix of these. If you’re an investor weighing the choice between a taxable bond and a tax-exempt bond, it’s important to think about how much income you’ll actually keep after taxes are deducted.
How Taxable Bond Works
All corporate bonds and some government bonds are taxable. For instance, Treasury securities are taxed federally but might be exempt from local and state taxes.
As mentioned earlier, most bonds that are issued fall under the taxable category, which means that the interest payments to investors are subject to taxation at either the federal or state level. The fixed or variable interest on a bond serves as income for bondholders, compensating them for lending money to the issuer for a set period. These payments are referred to as “coupon payments,” and they typically occur annually, semi-annually, or quarterly, based on the terms outlined in the bond purchase agreement.
At the end of the year, individuals who have invested in taxable bonds and received interest income must report the interest earned on their tax returns to their local and state governments, as well as to the federal government. If the bonds were issued at a discount and held until maturity, then redeemed for their face value, the bondholder would be responsible for taxes on the difference.
The Example
Think about a zero-coupon bond and a Treasury bill, which don’t pay any interest during the life of the bond. Instead, they’re sold at a discount and redeemed for their full value when they mature. For instance, an investor might buy a bond for $950 and get back $1,000 at maturity. The $50 difference is the profit from the investment and is taxed as interest income.
Even though the bondholder doesn’t actually receive interest income, the IRS treats the discount as imputed interest, which needs to be reported at the end of the tax year. But if the discount bond is sold before it matures, there will be a capital gain or loss that also needs to be reported for tax purposes.