Each year you have to pay tax on any investment income you earn. For instance, a savings account earning $2,000 in interest has to be added to any taxable income and you’ll be required to pay tax on it. There are some types of investments that can be partly, or even entirely tax free, meaning you don’t pay tax on interest or additional income that results from the investment. Bonds from local or state governments are the investors’ livelihood when it comes to investing without having a tax liability.
Bonds are one of the biggest ways that government entities and corporations raise money. Buying bonds is similar to loaning money for a specified amount of time to the person who issues it. The issuing agency makes interest payments on your bond at a rate determined when you purchase the bond. This is referred to as the “coupon rate”, and also agrees to cover the face value of the bond price when the time period expires. The interest payments you receive are typically taxable, but there are some bonds which might be tax free.
Municipal Bonds
These bonds are used by different government entities on local, state, and city levels. Sewer and water companies, as well as roadway authorities often use municipal bonds to fund different projects related to making the community a better place. Often, sewer systems, roadways, schools, and even hospitals are build using money earned through the sale of municipal bonds.
Interest earned on municipal bonds is most often exempt from federal tax, in an effort to help small governments raise funds for projects easier. If the purchaser lives in the state or locality in which the bond is issued, they are also exempt from local and state taxes as well.
Selling municipal bonds for profit will result in a capital gain, and will be subject to federal and state taxes on the profit amount. Most investors make their money off of interest payments as opposed to capital gains, so it’s less likely that a municipal bond will be taxed.
Municipal bonds have a lower interest rate payment than other bonds that are subject to taxes. However, depending on your tax rate, these bonds can really pay off when you get your tax return. Example: A person in the 25% tax bracket has a muni bond that earns 3% in interest. At tax time, that bond will result in the same payout as a taxable bond that earns 4%, because of taxable interest. The greater your tax bracket, the higher your return will be with nontaxable muni bonds. This is why rich individuals in a high tax bracket often invest in municipal bonds.
Federal Bonds
We’re all aware of how much money the federal government borrows, and some of it is done through bonds. They come in two forms: long term Treasury bonds and short term Treasury bills and notes. Interest from these investments are taxed by the federal government, but not by state or local governments. Both types usually pay interest twice a year (every six months) and you are required to report it as income in the year it was paid.
