Bonds
January 12, 2024
Unless you're buying a bond at issue and holding it to maturity, the tax rules for bond proceeds can get complicated pretty quickly.
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.
Who issued the bond?
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.
What type of proceeds did the bond generate?
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.
What was your purchase price?
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.
Bonds purchased at "par"
When the bond's purchase price is equal to its face value at maturity.
Interest income
- Federal taxation
- State taxation*
-
Corporate bonds
>
Federal taxation
Taxable
>
State taxation*
Taxable
>
-
Treasury bonds or notes
>
Federal taxation
Taxable
>
State taxation*
Not taxable
>
-
Municipal bonds†
>
Federal taxation
Generally not taxable
>
State taxation*
Generally not taxable if the bond is from the state in which you reside
>
- Disclosures
*Applies only to states that have an income and/or excise tax.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Capital gain or loss
- Sold prior to maturity*
- Held to maturity
-
Corporate bonds
Treasury bonds or notes
Municipal bonds†
>
Sold prior to maturity*
You could realize a capital gain or loss, depending on whether you sold the bond for more or less than the cost basis.
Note: This could result in a taxable capital gain even for municipal bonds.
>
Held to maturity
You will not realize a capital gain or loss because the principal you receive is equal to the cost basis.
>
- Disclosures
*Capital gains or losses will be either long or short term, depending on how long you've held the bond.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Bonds purchased at a "premium"
When the purchase price is more than the face value at maturity.
Amortization of bond premium
- Required or elective
- Effect on cost basis
- Effect on taxes
-
Corporate bonds
>
Required or elective
Elective
>
Effect on cost basis
If elected, the cost basis decreases as you recognize amortization.
>
Effect on taxes
If elected, your annual interest income is decreased as you recognize amortization.
See AlsoGuide to Investment Bonds and TaxesOffshore Bonds Explained: A Guide For Tax-Savvy InvestorsUnderstanding Taxation on Bonds | CPD Learning | abrdnOffshore bonds taxation explained>
-
Treasury bonds or notes
>
Required or elective
Elective
>
Effect on cost basis
If elected, the cost basis decreases as you recognize amortization.
>
Effect on taxes
If elected, your annual interest income is decreased as you recognize amortization.
>
-
Municipal bonds*
>
Required or elective
Required
>
Effect on cost basis
Cost basis decreases as you recognize amortization.
>
Effect on taxes
N/A
>
- Disclosures
*Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Interest income
- Federal taxation
- State taxation*
-
Corporate bonds
>
Federal taxation
Taxable
>
State taxation*
Taxable
>
-
Treasury bonds or notes
>
Federal taxation
Taxable
>
State taxation*
Not taxable
>
-
Municipal bonds†
>
Federal taxation
Not taxable
>
State taxation*
Generally, not taxable if the bond is from the state in which you reside
>
- Disclosures
*Applies only to states that have an income and/or excise tax.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Capital gain or loss
- Sold prior to maturity*
- Held to maturity
-
Corporate bonds
Treasury bonds or notes
Municipal bonds†
>
Sold prior to maturity*
You could realize a capital gain or loss, depending on the sale price relative to the cost basis.
Note: This could result in a taxable capital gain even for municipal bonds.
>
Held to maturity
Without amortization: You will realize a capital loss because the cost basis of the bond will be higher than the principal returned.
With amortization: You will not realize a capital gain or loss because the principal you receive is equal to the cost basis.
>
- Disclosures
*Capital gains or losses will be either long or short term, depending on how long you've held the bond.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Purchased at "discount"
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.
1. Original Issue Discount (OID)
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).
Accretion of bond discount*
- Required or elective
- Effect on cost basis
- Effect on taxes
-
Corporate bonds
>
Required or elective
Required
>
Effect on cost basis
Cost basis increases as you recognize accretion.
>
Effect on taxes
Your annual interest income is increased as you recognize accretion.
>
-
Treasury bonds or notes
>
Required or elective
Required
>
Effect on cost basis
Cost basis increases as you recognize accretion.
>
Effect on taxes
Your annual interest income is increased as you recognize accretion.
>
-
Municipal bonds†
>
Required or elective
Required
>
Effect on cost basis
Cost basis increases as you recognize accretion.
>
Effect on taxes
N/A
>
- Disclosures
*Accretion of OID on U.S. Government Series E, EE, and I bonds is optional.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Interest income
- Federal taxation
- State taxation*
-
Corporate bonds
>
Federal taxation
Taxable
>
State taxation*
Taxable
>
-
Treasury bonds or notes
>
Federal taxation
Taxable
>
State taxation*
Not taxable
>
-
Municipal bonds†
>
Federal taxation
Not taxable
>
State taxation*
Generally, not taxable if the bond is from the state in which you reside
>
- Disclosures
*Applies only to states that have an income and/or excise tax.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Capital gain or loss
- Sold prior to maturity*
- Held to maturity
-
Corporate bonds
Treasury bonds or notes
Municipal bonds†
>
Sold prior to maturity*
You could realize a capital gain or loss, depending on the sale price relative to the cost basis.
Note: This could result in a taxable capital gain even for municipal bonds.
>
Held to maturity
You don't realize a capital gain or loss because the principal returned is equal to the cost basis.
>
- Disclosures
*Capital gains or losses will be either long or short term, depending on how long you've held the bond.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
2. Market discount
This occurs when you a buy a bond on the secondary market at a discount after its original issue date.
Accretion of bond discount
- Required or elective
- Effect on cost basis
- Effect on taxes
-
Corporate bonds
Treasury bonds or notes
Municipal bonds*
>
Required or elective
Elective
>
Effect on cost basis
If elected, the cost basis increases as you recognize accretion.
>
Effect on taxes
If elected, your annual interest income is increased as you recognize accretion.
Note: This could result in taxable municipal bond income.
>
- Disclosures
*Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Interest income
- Federal taxation
- State taxation*
-
Corporate bonds
>
Federal taxation
Taxable
>
State taxation*
Taxable
>
-
Treasury bonds or notes
>
Federal taxation
Taxable
>
State taxation*
Coupon payments aren't taxable; however, the discount could be taxable.
>
-
Municipal bonds†
>
Federal taxation
Coupon payments aren't taxable; however, the discount could be taxable.
>
State taxation*
Generally, not taxable if the bond is from the state in which you reside; however, the discount could be taxable.
>
- Disclosures
*Applies only to states that have an income and/or excise tax.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
Capital gain or loss
- Sold prior to maturity*
- Held to maturity
-
Corporate bonds
Treasury bonds or notes
Municipal bonds†
>
Sold prior to maturity*
Any unrealized accretion could result in taxable ordinary income. In addition, you could realize a capital gain or loss depending on the sale price relative to the cost basis.
Note: This could result in a taxable capital gain even for municipal bonds.
>
Held to maturity
Without accretion: Any unrealized accretion could be treated as taxable ordinary income, even for municipal bonds.
With accretion: You don't realize a capital gain or loss because the principal returned is equal to the cost basis.
>
- Disclosures
*Capital gains or losses will be either long or short term, depending on how long you've held the bond.
†Municipal bonds in this chart are assumed to be general obligation bonds that qualify for the federal exemption. There are also private activity bonds that are exempt from federal income taxation but may be subject to federal alternative minimum tax and may not be exempt from taxation at the state level. If a municipal bond is non-qualified it may be treated as a taxable bond.
3. De minimis discount
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.
What if you buy between coupon payments?
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.
Bottom line
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.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Investing involves risk, including loss of principal.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.
Supporting documentation for any claims or statistical information is available upon request.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, anddoes not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
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