Taxation for Your Fixed Income Portfolio

Investors owning equities have some distinct tax advantages over those looking to own bonds and bond funds. For one thing, dividends and capital gains can be treated at favorable rates. Qualified dividends are only taxed at a 15% or 20% rate and, in some instances, maybe not at all. The same could be said for capital gains. Hold a stock for at least a year and you’ll pay just 15% on that gain. Again, that could also be zero depending on your tax bracket.

However, bond investors aren’t necessarily so lucky. Because they are essentially loans, bonds and bond funds pay interest rather than dividends, which has technically been taxed at the corporate level before. And interest is considered income. This makes the calculation for bond taxes a little difficult. Likewise, bonds and bond funds can generate capital gains.

The first part of the equation is the interest income that a bond generates. Depending on the kind of bond, it depends on who, if any taxing authority, gets the taxes. Interest income is taxed at ordinary income rates, i.e., your tax bracket.

For bond holders of U.S. Treasury bonds, notes, and bills as well as bonds of government agencies, the interest is taxed at the federal level. However, that interest income is generally exempt from state and local taxes. This could be a huge win for investors in high tax states.

Corporate bonds and mortgage-backed securities aren’t so lucky. Owning a bond issued by Walmart or Fannie Mae means that the bondholder will pay federal, state, and, if applicable, local taxes on the interest.

Municipal bonds are issued by states, counties, cities, and other government agencies. Interest from these bonds is generally not subject to federal income tax. The interest can also be exempt from state or local income taxes if the bond is issued by your home state. So, if you live in Texas and own a muni bond issued by the Texas government, the interest is tax-free. However, muni bonds issued by another state or city is taxable on your state or local income tax return.

While bonds generally aren’t used for appreciation, there can be situations when an investor sells their bonds at a premium to the price at which they purchased it. And just like owning a stock, this difference generates a capital gain. Depending on the holding timeline—under a year or over a year—investors will pay short-term or long-term capital gains taxes on the sale.

Holding a bond to maturity and getting your principal back is considered a return of capital and not taxable. However, if you buy a bond at a discount and hold it till it matures, the difference in your buying price and the return of principal is considered a capital gain.

Buying a bond fund rather than individual bonds creates another set of tax worries for investors. The distributions paid by the funds are taxed as if the underlying bonds were paying them out. If you own a fund that holds treasuries, you’ll owe federal but potentially not state or local taxes as pointed out above.

Capital gains can be a sticky subject for bond funds as investors may be subjected to double the gains.
 

• First, there’s the capital gains generated within the fund. As the fund manager buys and sells bonds, those gains are passed onto investors at the end of the year and are considered taxable. Bond ETFs circumvent this due to their creation/redemption mechanism.

• Second, investors generate their own capital gains when they sell shares of the fund itself.

Not all bonds fit within these ‘neat’ categories. Some offer unique tax points to consider, such as zero-coupon and treasury inflation protected securities (TIPS). Both these bond varieties don’t actually pay interest semiannually, but are bought at discounts to par. TIPS reset their par based on values to the CPI. However, investors are required to pay taxes on this phantom interest each year. Meanwhile, savings bonds and I-Bonds are technically zero-coupon bonds, but investors are able to defer taxes on the interest until sold.

Additionally, not all munis are tax-free. For instance, Build America Bonds are taxable at Federal and state levels, while private activity bonds may not be free from federal taxes and subject high-income earners to the dreaded AMT.

Given that most bonds do not offer favorable tax treatments, investors may want to consider holding them in tax-deferred or tax-free accounts like a 401k or Roth IRA. And if you need or want to hold them in a taxable account, then munis make the most sense from a tax point of view for most investors.

All in all, bonds and bond funds offer a different and, perhaps, less favorable tax treatment than equities. But knowing the basic ins and outs of how they are taxed could help investors make the most out of their bond holdings.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.