How are bonds taxed?

There is no qualified rate for bond interest. It is added to your income and taxed at your marginal rate, which for many people is materially higher than the 15% that applies to qualified dividends and long-term gains.

That is true whether the interest arrives from an individual bond, a bond fund or a bond ETF. The wrapper does not change the character of the income.

It is also taxable in the year credited, even if you reinvest it, and even if the bond itself has fallen in value.

Corporate bonds are taxed at every level: federal, state and local. They are the least favourable and usually pay the highest yield to compensate.

Treasury bonds, notes and bills are taxed federally but are exempt from state and local income tax. In a high-tax state that exemption is worth a meaningful amount of yield.

Municipal bonds are usually exempt from federal tax, and exempt from state tax too if you hold bonds issued by your own state. That is why their headline yields look low.

Because the tax treatment differs, comparing headline yields is meaningless. The comparison that works is the taxable-equivalent yield: what a taxable bond would need to pay to leave you with the same amount after tax.

A 3% municipal bond for someone in the 32% bracket is equivalent to a taxable bond yielding about 4.4%. For someone in the 12% bracket the same municipal is equivalent to roughly 3.4%, and a corporate bond is probably the better buy.

The right answer therefore depends on your bracket, not on the bond. Municipal bonds are generally worth it for higher earners and generally not for lower ones.

Hold to maturity and you receive the face value back, with no capital gain or loss on the principal.

Sell earlier and the price will have moved with interest rates. Selling above your basis produces a capital gain, long-term if held more than a year, taxed at the preferential rates. Selling below produces a deductible loss.

So a bond can generate ordinary income while held and a capital gain when sold, taxed under two different regimes in the same year.

Buying a bond above face value means paying a premium, which you can generally amortise over the remaining life, reducing the taxable interest each year.

Buying below face value creates a discount. If it is an original issue discount, a portion is treated as taxable interest each year even though you receive no cash for it, which is the phantom income that catches zero-coupon holders out.

Market discount, arising when you buy a seasoned bond cheaply, is generally taxed as ordinary income when the bond matures or is sold rather than as a capital gain.

Because interest is taxed annually at ordinary rates, taxable bonds held in a brokerage account give up part of their yield to tax every year.

Held inside a 401(k), IRA or HSA, the interest compounds untouched. For most investors that makes retirement accounts the natural home for taxable bonds and bond funds.

The exception is municipal bonds, which are already tax exempt. Holding them in a retirement account wastes the exemption entirely and leaves you with a lower yield for no benefit.

A bond fund distributes interest monthly, taxed as ordinary income, and can also distribute capital gains if the manager sold holdings at a profit.

Unlike an individual bond, a fund has no maturity date, so there is no point at which you are guaranteed your principal back. Rate moves show up as price changes you may eventually realise.

Municipal bond funds pass the federal exemption through, but a national fund holds bonds from many states, so only the portion from your own state escapes state tax.

Interest classification, bond premium and discount rules and 1099 reporting are in IRS Publication 550. Walnut is informational and is not an investment adviser. This guide is educational and not personalized tax or investment advice; anything with a tax consequence is worth confirming with a tax professional.