How to Avoid Overpaying Tax on Bond Investments

Worried about taxable payouts? Here’s what you should know about taxes and bond investments

For any investor, creating a balanced portfolio can take years of practice and market study – not to mention countless meetings with advisors. While bonds aren’t always the talk of the town, these usually-conservative investments do have their benefits.

Bond investments are often safe and practical. These negotiable promissory notes are often purchased to balance out investors’ portfolios, as bonds bring a steady, predictable income for a set period of time at a set interest rate. Bonds are fixed-income securities because if you keep the bond until its maturity, you will know exactly how much you’ll receive if the issuer can pay its debts.

When you purchase a government bond, you’re essentially lending money to the government that has to eventually be returned to you. As with any loan, interest accrues, and that’s how you make money.

There are ways to avoid paying high taxes on the bond interest you’ll accrue. In some cases, you can avoid paying taxes on your bond investment all together.

Municipal vs. U.S. Treasury bonds

Treasury bonds are purchased from the U.S. Treasury and are considered the most liquid type of bond, since they’re easy to buy and sell.

Series EE bonds are the most common type of bonds that the U.S. Treasury guarantees will double by the time it reaches maturity, which is often twenty years after purchase. Series I bonds earn combined fixed interest rates and variable inflation rates that are adjusted twice a year.

On these types of bonds, you can either pay taxes on interest annually or defer the interest until the bond matures or until you redeem it. But you have to choose an option and stick to it; waffling year to year is not allowed.

Only federal taxes apply to treasury bond interest, so you can avoid state and local taxes (in states where those taxes apply). So, if you live in a state that has high local tax rates, this can be a big plus.

Municipal bonds (or “munis” as they’re commonly known) are exempt from federal tax and in many cases state and local taxes as well, particularly when the bond was issued in the state where the purchaser lives. Puerto Rico municipal bonds are actually tax free in any state.

Municipal bonds are still issued by government units, but not at the federal level. Municipal bonds are a bit riskier than treasury bonds, making them perform better. And interest income from these bonds isn’t part of an individual’s adjusted gross income (AGI), which is good news for those who have exemptions, deductions, and credits phased out because of a high AGI.

All that being said, know that municipal bond proceeds could still be taxable. If bonds are bought at a discount in the secondary market, meaning that investors paid a different amount than face value for the bond, and then that bond is sold or reaches maturity, capital gains may accrue. These capital gains would be subject to federal and state taxes.

Additionally, these two types of bond income could be taxable: bonds sold after August 1, 1987 that were considered “private activity bonds,” which mean that private funds were secured for public-benefiting projects; or bond interest that is considered provisional income, which is related to Social Security benefits. Both may still be subject to minimum tax rates.

Roth IRA bonds

When you redeem bonds that you purchased through a Roth IRA that is managed by a custodian or trustee, you likely won’t have to pay taxes on those funds. These funds are often purchased from the U.S. Treasury, which registers the bonds under the trustee institution’s name. When bonds are kept in the Roth IRA for at least five years and they aren’t redeemed until you reach 59 ½, you’ll be able to avoid taxes.

Using proceeds for education costs

The IRS doesn’t tax Series EE and Series I bond interest that is used for higher education costs. There are limits to the amount you can use, however, and there are rules for how they’re distributed for your children or dependents’ education.

The person who purchased the bonds originally must be at least 24 years old, but if they’re using the money for a child’s education, the child doesn’t have to meet that age requirement. (In short: you can pay for your kid’s college tuition with bond proceeds without worrying about tax.) For this benefit to apply, education costs must be paid in the same year that the bonds are redeemed.

Are you ready to make smarter investments and grow your individual or business wealth? At Provident CPA & Business Advisors, we help our clients set and meet achievable goals that positively impact their communities.

We ensure that you do not overpay on taxes. We’ll also help you ensure your assets are protected and that both your business and wealth continue to grow. Get in touch with us today to learn more.

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