Bonds and Taxes

What is a Bond?
A Bond is simply an 'IOU' in which an investor agrees to loan money to a company or government in exchange for a predetermined interest rate. If a business wants to expand, one of its options is to borrow money from individual investors, pension funds, or mutual funds. 

The company issues bonds at various interest rates and sells them to the public. Investors purchase them with the understanding that the company will pay back their original principal (the amount the investor loaned to the company) plus any interest that is due by a set date (this is called the "maturity" date).

Bonds provide an important component of many financial plans, however there is the sticky matter of taxes you must address.

Most investors buy bonds for two basic reasons, Safety and/or Income. Bonds can provide some stability for your portfolio to counter the volatility of stocks while generating current or future income. If you own stocks, you don’t pay taxes on their growth until you sell and then at the capital gains rate and even dividends receive special tax treatment.

Taxing Situation

Bonds on the other hand may face immediate taxes, since you receive income usually twice a year.

Here’s how the tax situation breaks down per bond type:
U.S. Treasury issues – These notes and bills generate federal income tax liability, but no state or local income taxes.
Municipal Bonds – Municipals or munis are free of federal income tax and if you buy them in the state where you live, are free of state and local taxes. These are sometimes called “triple free.”
Corporate Bonds – Corporate bonds have no tax-free provisions.
Zero Coupon Bonds – Zero coupon bonds are sold at a deep discount and pay no annual interest.

The full face value is paid at maturity, however, the IRS computes the implied annual interest and you are liable for that amount even though you don’t actually receive it until the bond matures.

Guidelines

These are general guidelines for bonds and taxes and as you can see, municipal bonds are the best tax deal. Of course, the yield on munis reflects this benefit.

Investors don’t typically look to bonds to outperform stocks, although this happens from time to time, the main functions of bonds in a portfolio are diversification, stability and income.

Municipal bonds often offer triple-tax-free interest payments to investors because the U.S. Constitution forbids the federal government from taxing interest earned on loans to municipalities and states. 

Conclusion

If you are looking for diversification Bonds are worth taking a look at, they can provide relatively secure income at a reasonable return, municipal bonds are worth a look at also for their tax benefits.

If you are considering Retirement Planning, call for a free consultation today.


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