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. First, as debt securities they are technically safer than stocks when it comes to principal in the event of a bankruptcy or default. Second, they provide a consistent and predictable stream of interest income.
As a result, many find that bonds can provide some stability for their portfolio to counter the volatility of stocks, while they still generate income.
No Special Tax Treatment
Investors don’t typically look to bonds to outperform stocks, although this happens from time to time (and many an experienced bond trader would beg to differ). However, most investors see the function of maintaining bonds in their portfolio as a way to help 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.
Bond Types and Taxes
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 are notes and bills that generate a federal income tax liability, but no state or local income taxes.
- Municipal bonds sometimes are known as munis and 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 have no tax-free provisions. You will pay taxes on any earnings from these debt securities unless they're held in a retirement account like a 401(k) or IRA.
Zero-coupon bonds are a specific type of bond that has specific tax implications. These securities 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 receive it until the bond matures. Yes, you read that correctly. You're taxed now on the income you haven't received yet and might not receive for years to come.
As you can see, municipal bonds are the best tax deal. The yield on munis reflects this benefit and will usually be at a lower rate than other bonds.
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 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 24% tax bracket and you're considering a muni with a yield of 2.8%, the calculation would look like this:
0.028 / (1 – 0.24) = 3.68%
This muni would give you the same effective return as taxable security that pays about 3.68%. If you add in state and local taxes, it could push your taxable equivalent return even higher.
Of course, stocks have always outperformed bonds over the long term. However, if you're looking for relatively secure income at a reasonable return, municipal bonds are worth a look for their tax benefits. Depending on your goals, you may find a place for them in your portfolio as part of a diversification strategy.