Is Bond Interest Taxed as Ordinary Income?

Investors often look at bonds as a hedge against stock market volatility. While bond investments don’t have the same potential upside as equities, they may balance an investor's portfolio. Unfortunately, that strategy doesn't always work as hoped. 2022 is a good example, as bonds dropped along with stock market returns.

There are different types of bonds.

Treasury bonds are widely favored, and the yields are a benchmark for fixed-income investments. The US government guarantees US Treasury bonds, which are therefore considered secure investments. There are four types of US Treasury debt:

•       Treasury bills, which mature within a year.
•       Treasury Notes, which mature within ten years.
•       Bonds, which are longer-term offerings that pay interest twice yearly and mature in 30 years.
•       TIPS (Treasury Inflation-Protected Securities) have adjustable principal amounts and maturity periods of five to thirty years.

Interest from Treasury Bonds is taxable and treated as ordinary income. Typically, the interest from US bonds is not taxed at the state and local level.

Municipal bonds, in contrast, are issued by other levels of government, including states and municipalities. These bonds are usually exempt from federal income tax, but the interest might be taxable at the state and local level, depending on your residence and the issuing entity’s rules. Municipal bonds also have multiple forms: general obligation bonds, where the issuing entity promises to pay the bondholders using taxes if necessary, or revenue bonds, which means the bonds fund a project that, in turn, produces income to repay the bondholders.

Sometimes, local governments issue conduit bonds to benefit private organizations like colleges and hospitals. The designated entity is responsible for paying the issuer, which pays the purchasers.

Corporate bonds are also debt obligations, but individual companies rather than government entities issue them. Unlike buying a share of company stock, the bond purchaser is promised a specific return. As a result, purchasing a corporate bond does not offer the same level of risk or opportunity for potential reward that buying a stock does.

Do I pay capital gains taxes on bonds?

Bond interest income is typically taxed as ordinary income at the rate associated with the taxpayer's overall income. The investor owes taxes for interest income in each year they receive it. Since bonds’ issue prices are returned at maturity, the interest is the profit, and that is not a capital gain.

However, it is possible to owe capital gains taxes in some cases. If, for example, an investor buys a municipal bond in the secondary market at a discount and owns it until it reaches maturity, that could cause a capital gain if the difference between the issue price and the discount price is significant.

Why consider bonds?

Investors sometimes buy bonds to balance risk in their investment portfolio. Advisors debate the benefits of various portfolio mixes, but each investor can decide on the distribution that matches their risk appetite. Since bonds are relatively stable, they may serve as a balance to riskier options like equities.

Furthermore, if you hold bonds in a tax-advantaged account, such as your 401(k), the income generated by the bond is deferred until you begin taking distributions from the account, typically after retirement.