Bond interest is usually taxed as ordinary federal income at rates from 10 to 37 percent, but how bond interest is taxed depends on who issued the bond. Corporate bond interest is fully taxable at the federal, state, and local levels. U.S. Treasury interest is taxed federally but exempt from state and local tax. Interest on municipal bonds is generally free from federal tax and often free from state tax as well when you buy a bond issued by your own state. A few extra rules — around inflation-adjusted Treasuries, zero-coupon bonds, sales before maturity, and a surtax for higher earners — can change the final bill.
Corporate Bond Interest Is Fully Taxable
Interest on corporate bonds goes into your gross income and is taxed at ordinary federal rates, the same rates that apply to your wages.1Office of the Law Revision Counsel. 26 U.S.C. 61 – Gross Income Defined It does not qualify for the lower rates that apply to qualified dividends. Your state and locality tax it as well, and some state rates exceed 13 percent. Whether the issuer is domestic or foreign, and whatever the coupon or maturity, the treatment is the same.
The one way to keep current tax off corporate bond interest is to hold the bonds inside a tax-advantaged account such as a traditional IRA, Roth IRA, or 401(k).
Accrued Interest When You Buy Between Payment Dates
If you buy a bond between scheduled interest payments, you pay the seller for the interest that has built up since the last payment. The next full interest payment then comes to you, but the portion that covered the seller’s period isn’t really your income. On Schedule B, list the full interest amount from your 1099-INT, then subtract the accrued interest you paid at purchase and label it “Accrued Interest.”2Internal Revenue Service. Instructions for Schedule B (Form 1040)
Treasury Interest: Federal Only, No State or Local Tax
Interest on Treasury bills, notes, bonds, TIPS, and U.S. savings bonds is subject to federal income tax at your ordinary rate.3Internal Revenue Service. Topic No. 403, Interest Received It is completely exempt from state and local income tax under a federal statute that bars states from taxing U.S. government obligations or the interest they produce.4Office of the Law Revision Counsel. 31 U.S.C. 3124 – Exemption From Taxation You don’t need to file anything special to claim the exemption. You either leave Treasury interest off your state return or enter it as an adjustment, depending on the form your state uses. In high-tax states this is a real advantage, and some investors buy Treasuries specifically for it.
TIPS Create Phantom Income
The principal on a Treasury Inflation-Protected Security adjusts up or down each year with inflation. The IRS treats an upward adjustment as taxable interest in the year it happens, even though no cash reaches you until the bond matures. You owe tax on money you haven’t yet received. The state and local exemption still applies.
Savings Bonds Used for Education
If you cash in Series EE or Series I savings bonds and use the proceeds for qualified higher education expenses for yourself, your spouse, or a dependent, you may be able to exclude some or all of the interest from federal tax.5TreasuryDirect. Tax Information for EE and I Bonds The bonds must have been issued after 1989 in your name (or jointly with your spouse), and you must have been at least 24 when they were issued. The exclusion phases out at higher incomes and is not available to married taxpayers filing separately. You claim it on IRS Form 8815.
Municipal Bond Interest Is Usually Free From Federal Tax
Interest on bonds issued by states, cities, counties, and other local government entities is generally excluded from federal gross income.6Office of the Law Revision Counsel. 26 U.S.C. 103 – Interest on State and Local Bonds That exemption is why municipalities can borrow at lower rates while still offering competitive after-tax yields.
State tax treatment turns on where the bond was issued. Buy a bond from your own state, and the interest is often exempt from state and local income tax too, sometimes called triple tax-free. Buy one from a different state, and your home state will generally tax that interest at its normal rate. Rules vary, so check your state’s tax code.
Private Activity Bonds and the AMT
Not every muni escapes federal tax. Interest on certain private activity bonds, whose proceeds fund private projects rather than public ones, counts as a tax preference item for the Alternative Minimum Tax.7Office of the Law Revision Counsel. 26 U.S.C. 57 – Items of Tax Preference If the AMT applies to you, that interest gets added back in the AMT calculation. The issue mainly affects higher-income investors. Qualified 501(c)(3) bonds, certain housing bonds, and qualified veterans’ mortgage bonds are excepted.
Comparing a Muni Yield to a Taxable Yield
Because muni interest is tax-free, a muni paying 4 percent can beat a taxable bond paying more. To compare fairly, divide the muni yield by one minus your marginal tax rate. In the 24 percent bracket, 4.00% ÷ (1 − 0.24) = 5.26%. A 4 percent muni gives you the same after-tax return as a 5.26 percent taxable bond. The higher your bracket, the more the exemption is worth.
Zero-Coupon Bonds and Original Issue Discount
Some bonds pay no periodic interest. Zero-coupon bonds sell well below face value, and you collect the face value at maturity. The spread is called original issue discount, or OID. You cannot defer all that income to the end. The IRS makes you report a portion of the OID as interest each year you hold the bond, calculated using a constant-yield method tied to yield to maturity.8Office of the Law Revision Counsel. 26 U.S.C. 1272 – Current Inclusion in Income of Original Issue Discount You owe tax on that amount even though no cash has changed hands. Each year, your cost basis rises by the OID you reported, so the same dollars aren’t taxed again at maturity.
A de minimis rule spares you the annual reporting when the discount is small. The threshold equals 0.25 percent of face value multiplied by the complete years to maturity.9eCFR. 26 CFR 1.1273-1 – Definition of OID On a $1,000 face bond with 10 years to maturity, the de minimis amount is $25. Below that, the OID is treated as zero for annual purposes, and the discount is recognized only when the bond matures or you sell it, where it’s taxed as capital gain rather than ordinary income.10Internal Revenue Service. Guide to Original Issue Discount (OID) Instruments
Selling a Bond Before Maturity
Bonds are capital assets. Selling one before maturity produces a capital gain or loss equal to the difference between your adjusted basis and the sale price.11Internal Revenue Service. Topic No. 409, Capital Gains and Losses Hold longer than a year and any gain qualifies for the lower long-term capital gains rate. Hold a year or less and the gain is taxed at ordinary rates.
Market Discount Bonds
If you bought a bond on the secondary market for less than face value, special rules apply at sale or maturity. Gain up to the amount of the accrued market discount is treated as ordinary income, not capital gain.12Office of the Law Revision Counsel. 26 U.S.C. Subpart B – Market Discount on Bonds Only gain above the accrued discount gets capital gains treatment. You can elect to include the market discount in income each year as it accrues, which avoids the ordinary-income recapture later but means paying tax sooner.
The Wash Sale Rule
Sell a bond at a loss and buy a substantially identical bond within 30 days before or after the sale, and the IRS disallows the loss under the wash sale rule.13Office of the Law Revision Counsel. 26 U.S.C. 1091 – Loss From Wash Sales of Stock or Securities The statute covers stock or securities, and bonds qualify. The disallowed loss is added to your basis in the replacement bond, so the deduction isn’t gone forever. You just can’t claim it until you sell the replacement without triggering another wash.
The 3.8 Percent Surtax for Higher Earners
Higher-income investors owe an additional 3.8 percent net investment income tax on top of regular income tax. The NIIT applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds these thresholds:14Internal Revenue Service. Topic No. 559, Net Investment Income Tax
- $250,000 for married filing jointly or qualifying surviving spouse
- $200,000 for single or head of household
- $125,000 for married filing separately
Net investment income includes taxable bond interest and capital gains from bond sales. Tax-exempt municipal interest excluded under 26 U.S.C. § 103 is not counted. The thresholds are not adjusted for inflation, so more taxpayers cross them each year as incomes rise.
What You’ll Receive and What You File
Any payer who sent you $10 or more in interest during the year must send you a Form 1099-INT showing the amount and any tax withheld.15Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID Tax-exempt muni interest of $10 or more also appears on the 1099-INT, in Box 8. You still report it on your return even though it isn’t taxable.
If you hold a bond with OID, you’ll receive a separate Form 1099-OID once the annual accrual reaches $10. Look for both forms when gathering records. OID on short-term obligations of one year or less to maturity is reported on Form 1099-INT instead.
File Schedule B with your Form 1040 if your total taxable interest or ordinary dividends exceed $1,500.2Internal Revenue Service. Instructions for Schedule B (Form 1040) Below that, the interest still goes in your total income. The $1,500 threshold only decides whether Schedule B itself is required. Match your reported figures to what appears on your 1099s. The IRS receives copies from payers and runs automated matching to flag anything that doesn’t line up.