Bond Tax Rules
Most financial advisors recommend the inclusion of bonds in every investment portfolio since they provide security in volatile market conditions. At the same time they generate either current or future income to their holders. However, there are certain tax implications that you should keep in mind when you decide to purchase bonds.
The tax implications of stocks are simple: their growth is tax-free until their sale and at the capital gains rate. The situation with bond taxation is quite different than the one found in stocks. Since you receive income from the bonds you hold on a regular basis, you may face taxation. The taxation rules are as follows for the different types of bonds:
- US Treasury Bonds
Issues of US Treasury bonds are exempt from state and local taxes. However, you are liable to federal income taxes.
- Corporate Bonds
Unfortunately, corporate bonds don't enjoy any tax privileges.
- Zero Coupon Bonds
Although the interest you have gained is accumulated and paid at the time the zeros mature, you are still liable to taxes.
- Municipal Bonds
This type of bonds is free from federal income taxes. Only in the case of purchasing them within the state of your residence you will be also exempt from state and local taxes.
As it can be seen, munis offer one of the best tax provisions among the types of bonds. However, when you purchase such bonds you will have to live up with lower yields in return to the tax privileges.
Municipal Bond Taxable Equivalent Calculation
In order to make a quick comparison between stocks and municipal bonds use the following formula:
Muni yield / (1 - marginal tax rate) = taxable equivalent
If you are a conservative type of investor, bonds are the right choice for you. However, you should always keep in mind that bonds rarely or almost never outperform stocks, so you should include the first in your portfolio for the purposes of security and balance.
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