You may be overpaying or underpaying taxes on your bond income and not even know it. Bond taxation is complex because there are several considerations that require different tax treatments. If a bond is purchased at par and held to maturity, it is fairly simple. If it’s a taxable bond, you pay income tax on the coupon income. If it’s a tax-free municipal bond, you don’t.
But most bond purchases are not that simple. Bonds are generally purchased on the secondary market at a premium or a discount. Some bonds are purchased at original issue, but at a steep discount to their face value, such as zero-coupon bonds. Some bonds are federally tax-exempt, some state tax-exempt, some are both federal and state tax-exempt.
For various reasons bonds may be called or sold before maturity. The timing of the sale can have a significant impact on the taxable gain or loss at the time of the sale.
The complexity of bond taxation and tracking the basis of individual bonds is one of the reasons investors use bond mutual funds. Using a bond fund is much simpler, and the bond fund managers provide the necessary information for your tax returns. But there are trade-offs. Individual bonds offer advantages such as predictability of income, cost, flexibility, and safety. If properly managed, these advantages will significantly outweigh the simplicity of most bond mutual funds.
Let me give a couple of examples of how you might be overpaying your taxes on bonds you own (or might purchase).
Zero-coupon bonds are a good, safe investment if you want to provide a specific amount of money for a purpose some specific time in the future, such as college or a new car. Zero-coupon bonds don’t make coupon interest payments like most bonds, but are purchased at a deep discount to face value, also known as an OID (Original Issue Discount), and are redeemed at full face value when they mature. The difference between the face value of the bond and the discounted offering price is treated as interest, which is prorated over the term of the bond and taxed annually as ordinary income. The issuer or brokerage firm will send you a form 1099-OID showing the amount of interest you have to report on your tax return each year. But zero-coupon bonds can be purchased after original issue with an “acquisition premium”. This acquisition premium, if properly reported, can reduce the amount of OID includible in your income.
Another easily-overlooked tax consideration is the purchase of municipal bonds at a premium. This is very common in periods of low interest rates that we see today. Investors are willing to pay premium prices for bonds paying coupon interest of 4%-5% tax free. But often overlooked is that the premium must be amortized over the life of the bond. This is necessary to reduce the bondholder’s tax basis in the tax-free bond to determine if there is a capital gain or loss upon disposition. Generally no reduction for premium amortization is allowed since the interest is not taxable, but if the bonds are taxable (out-of-state) bonds, the taxable income can be reduced by the amount of premium amortization. The year-end 1099 sent out by brokerage firms only show how much tax-exempt interest was earned during the last year. Some states will filter out the bond amortization on out-of-state municipal bonds, but most states, and tax software, use whatever is listed on line 8b of your 1040. This can lead to the overpayment of state income taxes.
In summary, if you want to take advantage of the many benefits of purchasing individual bonds, it is important that your investment advisor, accountant, or both thoroughly understand how to track the annual adjusted basis of your bonds and tax benefits that are available to you.