How government bonds are taxed | Vanguard (2024)

FAQs

How government bonds are taxed | Vanguard? ›

Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes. * You will, however, have to report this income when filing your taxes.

What Bonds Are Tax Free? While investors will pay federal taxes on the interest income from government bonds, they won't owe state and local taxes. Investors in municipal bonds can avoid taxes altogether if they live in the area where the muni is issued.

Use the Education Exclusion

You can skip paying taxes on interest earned with Series EE and Series I savings bonds if you're using the money to pay for qualified higher education costs. That includes expenses you pay for yourself, your spouse or a qualified dependent.

Instead, it is taxed as regular income at the federal level and exempt from state and local taxes. The tax is due in the year when the bonds are redeemed or reach maturity, whichever comes first, and investors have the option to defer the payment of taxes until that time.

Zero-coupon municipal bonds, which are bought at a discount because they do not make any interest or coupon payments, don't have to be taxed. In fact, most aren't. As long as you're investing in a local municipal bond, taxes won't be a concern. This provides a big advantage over taxable bonds, even with lower interest.

After 20 years, it doubled in value ($1,000) and continued to earn interest ($600) until reaching maturity after 30 years. If you redeem your bond today, you can redeem it for $1,600 and spend that on goods or services or reinvest that money in a new savings bond.

Both bonds and notes pay interest every six months. The interest rate for a particular security is set at the auction. The price for a bond or a note may be the face value (also called par value) or may be more or less than the face value. The price depends on the yield to maturity and the interest rate.

But while they are lauded for their security and reliability, potential drawbacks such as interest rate risk, low returns and inflation risk must be carefully considered. If you're interested in investing in Treasury bonds or have other questions about your portfolio, consider speaking with a financial advisor.

Taxation of federal government bonds

Income from bonds issued by the federal government and its agencies, including Treasury securities, is generally exempt from state and local taxes.

Do you pay capital gains on bonds? ›

If you buy a bond when it is issued and hold it until maturity, you generally won't have a capital gain or loss. If you sell the bond before its maturity date, you'll typically have a capital gain or capital loss, depending on the selling price.

Another thing to note: Savings bonds don't get a step-up in basis at death the way stocks or other investments do. That means you have to pay tax on the full amount of interest due on the bonds as the inheritor.

Interest from Treasury bills (T-bills) is subject to federal income taxes but not state or local taxes. The interest income received in a year is recorded on Form 1099-INT. Investors can opt to have up to 50% of their Treasury bills' interest earnings automatically withheld.

Interest income generated by municipal bond funds is generally not subject to federal taxes, and may also be exempt from state and local taxes if the bonds held by the fund were issued by the state in which you live.

If interest rates rise, the value of your zero coupon bond on the secondary market will likely fall. Long-term zeros can be particularly sensitive to changes in interest rates, exposing them to what is known as duration risk. Also, zeros may not keep pace with inflation.

Municipal Bonds

Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes. In addition, interest on the bonds is exempt from State of California personal income taxes.

Owners can wait to pay the taxes when they cash in the bond, when the bond matures, or when they relinquish the bond to another owner. Alternatively, they may pay the taxes yearly as interest accrues. 1 Most owners choose to defer the taxes until they redeem the bond.

Municipal bonds are generally exempt from federal taxes and, in many cases, state and local taxes as well. As the saying goes, "nothing is certain in life but death and taxes," and this adage seems especially true for bond investors.

For bonds with very small discounts: If the discount is less than 0.25% of the bond's face value times the number of years to maturity, the discount is taxed as a capital gain in the year the bond matures.

Interest from municipal bonds issued to finance projects with no obvious public benefits is taxable since the federal government will not subsidize the financing of these projects.