Taxable Bond Definition

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Taxable Bond Definition

What Is a Taxable Bond?

A taxable bond is a debt instrument (i.e., a bond) whose return to the investor is taxed at the local, state, or federal level, or a combination of these levels. When deciding whether to invest in a taxable bond versus a tax-exempt bond, investors should evaluate how much income they will have after taxes are deducted.

Key Takeaways

  • Taxable bonds are subject to bondholder taxes.
  • The majority of bonds are taxed. Only bonds issued by local and state governments (i.e., municipal bonds) are generally free from taxation, and even then, specific conditions may apply.
  • If you redeem the bond before its maturity date, you must pay tax on both the interest payments and the capital gains.

How Taxable Bonds Work

Taxable bonds include all business bonds and certain government bonds. Treasury securities, for example, are taxed at the federal level but may be exempt from municipal and state taxes.

As previously noted, the majority of bonds issued are taxable bonds, which means that the interest payments made to investors are taxable at the federal and/or state levels. Fixed or variable interest on a bond is income provided to bondholders in exchange for lending cash to the issuer for a certain period of time. These payments are known as “coupon payments,” and they are normally given on a yearly, semi-annual, or quarterly basis, depending on the terms and circumstances outlined in the bond purchase agreement.

People who have invested in taxable bonds and earned interest income are obliged to disclose the amount of interest received on the bonds on their tax forms to their local, state, and federal governments at the end of the year. If the bonds were issued at a discount and held until maturity before being redeemed at face value, the bondholder would be taxed on the spread.

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Municipal Bonds and Tax Exemption

Municipal bonds, on the other hand, are not subject to federal taxation and may be free from state taxation if the bondholder lives in the state where the bonds are issued.

Some municipalities issue taxable bonds to fund initiatives that do not benefit the general public. Because the federal government would not assist the funding of these projects, interest on municipal bonds issued to finance initiatives with no evident public benefit is taxed. Taxable municipal bonds give risk-adjusted yields equivalent to those available from other taxable entities such as corporate bonds and other government agency bonds since income from such bonds is taxable in the investor’s hands.

Specific universities, for example, may issue taxable bonds via municipal authorities to fund the construction of new buildings or the extension of some department wings. These bonds, on the other hand, return the market rate rather than the reduced return rate given by tax-free bonds.

Examples of Taxable Bonds

Consider a zero-coupon bond and a Treasury bill, both of which do not pay interest for the life of the bond. They are instead sold at a discount and redeemed at face value on the maturity date. For example, an investor may buy a bond for $950 and get a $1,000 face value when it matures. The $50 difference is the investment return and is taxed as interest income.

Even though the bondholder does not receive interest income, the Internal Revenue Service (IRS) considers the discount to be imputed interest and requires reporting at the end of the tax year. If the discount bond is sold before maturity, a capital gain or loss must be declared in order to be taxed appropriately.

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