How Are Corporate Bonds Taxed?

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How Are Corporate Bonds Taxed?

A corporate bond is taxed in three ways: first, on the interest earned on the bond, secondly on capital gains or losses made on the bond’s early sale, and third, on an initial issue discount. The overall amount of taxes owing on these components adds up to the total amount of taxes owed on a corporate bond.

Key Takeaways

  • Corporate bonds are taxed on income earned, capital gains, and issue discounts.
  • Interest is taxed both federally and stately and is normally paid every six months. Only when the bond is sold are capital gains taxes owed.
  • Corporate bonds pay the greatest taxes when compared to other bonds, but they also provide the highest return.

Interest

The interest you earn on a business bond is taxed at both the federal and state levels. These are the standard taxes that must be paid on a typical corporate bond. Interest payments are generally predictable in terms of both the magnitude and the time of the payment, allowing the bond owner to determine the precise amount of taxes he will owe on interest.

Capital Gains

Because an investor may only get capital gains from a corporate bond if he sells the bond before it matures, capital gains taxes are less conventional than interest taxes. If an investor sells a bond for a profit before it matures, the amount received in excess of the initial purchase price is called a capital gain and is taxed at the investor’s regular income tax rate. If the investor sells the bond after more than a year but before it matures, he will be taxed at the long-term capital gains rate.

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Issue Discount

In rare situations, a bond is issued at a far lower price than its par value. When this occurs, such as when purchasing a zero coupon bond, the difference between the par value and the first offer price is referred to as the original issue discount, and it is taxed. This form of tax is sophisticated, and an investor should seek the advice of a tax specialist before acquiring a bond with an original-issue discount.

Corporate Bonds vs. Other Bonds

Although corporate bonds are the most basic kind of bond and the most widely accessible, they are the least tax favorable. Almost every aspect of a corporate bond is taxed. Corporate bonds, on the other hand, offer the highest rates since they represent the largest default risk.

Meanwhile, US Treasuries, such as notes and bills, are taxed at the federal level but not at the state or municipal level. Municipal bonds provide the greatest tax benefits of any bond. They are free from federal income taxes, and if purchased in your home state, they are also exempt from state and local taxes.

There are, however, zero-coupon bonds with tax consequences. These bonds are offered at a significant discount to regular bonds since they do not pay interest or coupons. When the investment matures, the investor receives the entire face value. The problem is that the IRS will compute the bond’s implied yearly interest and charge you taxes on it every year, even if you don’t get the money until maturity.

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