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Government bonds are a popular way for investors to save for the future and earn income. However, it’s crucial to understand the tax implications of these bonds before investing. Different types of government bonds — such as Treasury bonds, municipal bonds and savings bonds — are subject to varying tax treatments at the federal, state and local levels.
Here’s a breakdown of how government bonds are taxed and why it matters for investors.
How taxes on government bonds work
Government bonds are subject to varying tax treatments at the federal, state and local levels. For example, Treasury bills, notes and bonds are subject to federal income tax but exempt from state and local taxes. On the other hand, municipal bonds issued by state or local governments generally offer interest income that is exempt from federal taxes and often exempt from state and local taxes in the issuing state.
However, nuances do exist: Some states may choose to tax interest on their own bonds, while others may exempt specific bonds. It’s also important to note that the tax treatment of interest income from bonds does not change based on the length of time the bond is held. However, capital gains taxes may apply if bonds are sold before maturity.
Bonds held in tax-advantaged accounts, such as an IRA or other retirement account, avoid these taxes altogether.
How are government bonds taxed?
The taxation of government bonds depends largely on the type of bond and the issuing authority. However, there are common themes that apply to all types of government bonds. For example, when taxed, interest income from government bonds is taxed as ordinary income at the same rate as any other income. However, there are exceptions.
Capital gains taxes on bonds
Capital gains taxes come into play when you sell your government bonds before their maturity date. If you sell your bond for more than you paid, the difference could be considered a capital gain and would be subject to taxes. If you sell your bond for less than you paid, this could be a capital loss and can be used to offset other gains.
The tax rate applied to these capital gains depends on the length of time the bond was held. Short-term gains from bonds held for less than a year are taxed at your ordinary income tax rate, while long-term gains from bonds held for more than a year are taxed at a lower rate, typically either 0 percent, 15 percent or 20 percent, depending on your income level. This distinction between short-term and long-term capital gains taxes is one reason why the holding period of your bonds can significantly impact your net return.
Treasury bond taxes
Treasury bonds, which are issued by the federal government, have unique tax implications. Interest income from Treasury bonds is subject to federal income tax but exempt from state and local taxes. This exemption can be particularly beneficial for investors in high-tax states.
Additionally, if you sell your Treasury bonds before their maturity, you may be subject to capital gains taxes. The rate of tax applied to these gains depends on whether the gain is categorized as short-term or long-term, as per the criteria explained earlier.
Municipal bond taxes
Municipal bonds issued by local or state governments generally offer interest income that is exempt from federal taxes. Moreover, if you live in the state where the bond is issued, you may also be exempt from state and local taxes. However, it’s essential to note that this isn’t always the case because tax laws vary from state to state.
Also, while the interest income may be tax-free, capital gains from selling municipal bonds are subject to taxation. Additionally, private activity bonds, a type of municipal bond, are typically exempt from federal taxes but some are subject to tax under the alternative minimum system tax.
De minimis tax rule explained
The de minimis tax rule is a regulation that determines how the discount on a government bond (if it was purchased at a discount) is taxed. According to this rule, if the discount at which a bond is purchased in the secondary market is less than 0.25% of the face value for each full year from the purchase date to the bond’s maturity, the accretion (or price appreciation) is considered de minimis, or too small, and is taxed at the capital gains rate.
However, if the discount exceeds this threshold, the accretion is taxed as ordinary income, which can result in a higher tax rate. This rule can significantly impact investors, particularly in a rising interest rate environment where more bonds might fall below the de minimis threshold, leading to higher taxes and potentially affecting bond prices and liquidity.
Consider consulting with a tax advisor to understand whether the de minimis tax rule applies to bonds you own.
Bottom line
When it comes to the taxation of government bonds, understanding the nuances is critical to optimizing your investment strategy. Whether it’s Treasury bonds or municipal bonds, the tax implications vary based on the type of bond and the issuing authority. The holding period also plays a significant role, particularly in terms of capital gains taxes.
Additionally, special rules, such as the de minimis tax rule, can have a profound impact on your tax obligations. Therefore, it’s advisable to consult with a tax or financial advisor to ensure you’re making the most of your investments while minimizing your tax liability.
You may also want to use a tax-equivalent yield calculator to compare taxable bonds with tax-advantaged bonds.
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