For new investors, it can be hard to determine your tax liabilities from your investments. Reading up on the available types of bonds and their tax consequences can help you make informed decisions on your investments and how they are taxed.
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When people talk about investing, the phrase "stocks and bonds" tends to come up a lot. But why exactly should you invest in either of these options? Understanding the basics of investing in bonds is an important part of getting started as an investor and choosing the best investments for yourself.
Here's a guide to help you determine why you might invest in bonds, the types of bonds available, and what else you need to know about this crucial piece of an investment portfolio.
When you purchase a bond, you're essentially lending money to a company or government. Companies and governments issue bonds to raise money for business operations, expansions or large infrastructure projects.
Over the bond's term, you earn interest on the amount of the bond at an agreed-upon rate. This rate is typically fixed for the life of the bond it can change for some bonds. That fixed, agreed-upon interest rate is why bonds are also typically known as "fixed income" investments — because you get back a fixed amount. On most bonds’ maturity date, you receive back the bond's par or face value.
When a bond is first issued, the price you pay for the bond is usually its par value. For example, you might purchase a bond with a par value of $1,000 at a 4% interest rate (also known as its coupon rate).
After a bond is issued, investors can also sell it before its maturity date. At this point, the bond may sell at a "premium" or "discount." When an existing bond offers a higher coupon rate than the rate currently offered on new bonds, it typically trades above (premium) its par value on the secondary market and becomes a premium bond.
When a bond offers a lower coupon rate than the rate currently offered on new bonds, it typically trades below (discount) its par value and becomes a discount bond.
Investing in bonds offers several advantages over other investments. First, they're a relatively safe investment compared to stocks because their value doesn't usually fluctuate as much as stock prices do. This is why they're a popular option for diversifying your investment portfolio. While bonds typically don't generate the big returns that investing in stocks may deliver, they can provide stability for your investment portfolio. Having a mix of both stocks and bonds can reduce your financial risk when the stock market fluctuates.
Another advantage of investing in bonds is their predictable income stream. Because bonds pay a fixed amount of interest (typically paid twice per year), you can typically count on that income. Depending on the type of bond you invest in, that income may even be tax-free.
Of course, like other types of investments, there is some element of risk when investing in bonds. While it's uncommon, the bond issuer can default on its bond obligations. When that happens, you can lose out on interest payments, not get your initial investment back, or both.
If you buy a bond when it is issued and hold it until maturity, you generally won't have a capital gain or loss. If you sell the bond before its maturity date, you’ll typically have a capital gain or capital loss, depending on the selling price.
Bonds come in a variety of forms. Here are some of the most common categories.
To invest in corporate and municipal bonds, you typically must use a broker. You can buy treasury bonds directly from the U.S. government through TreasuryDirect without going through a broker.
For some investors, selecting individual investment bonds can be intimidating. That's why many people choose to invest in bond mutual funds rather than individual bonds. Bond mutual funds hold a large number of bonds with a variety of maturity dates, interest rates, and credit ratings. This can make it much easier to diversify your bond portfolio because the fund invests in the bonds and you have an interest in a small amount of each bond within the fund rather than investing a large sum into a single bond.
Bonds are typically taxed in two ways: when you earn interest on the bond and any capital gain on the sale.
When you earn interest, the IRS expects you to report that income on your tax return. Whether or not that income is taxable depends on the type of bond you invest in.
After the end of the tax year, your financial institution or the bond issuer should send you a Form 1099-INT reporting all the taxable and tax-exempt interest you received during the year. Typically, interest from corporate bonds will be in Box 1, interest from U.S. Treasuries will be in Box 3, and tax-exempt interest from muni bonds will be in Box 8.
Even if you don't have to pay income tax on the interest, you still need to include it on your tax return. That's because, while some bond interest is tax-exempt, the IRS still includes it in some calculations. Perhaps most notably, if you receive Social Security income, tax-exempt municipal bond interest can impact how your Social Security benefits are taxed.
The IRS includes muni bond interest in your modified adjusted gross income. If half of your Social Security benefit plus other income, including tax-exempt muni bond interest, is between $32,000 and $44,000 for a joint tax return ($25,000 to $34,000 for single filers), up to 50% of your Social Security benefits may be taxable. Above those thresholds, up to 85% of your benefits could be taxed.
If you buy a bond when it is issued and hold it until maturity, you generally won't have a capital gain or loss. However, if you sell the bond before its maturity date for more than you paid for it, you'll typically have a capital gain. If you sell it for less than you paid for it, you'll usually have a capital loss.
After the end of the tax year, your financial institution will send you a Form 1099-B reporting any bond sales that took place during the year.
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