Bonds can be taxable or tax-free - here's your guide to the different types and calculating what's due on them

Bonds and bond funds generate two types of income: interest and capital gains.
Interest income from a bond may be taxable or tax-exempt, depending on the type of bond.
Capital gains from selling a bond before maturity are always taxable unless it's in a tax-advantaged account.
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All investments generate income in one way or another - sometimes as you hold them, sometimes only when you sell them for a profit. And that investment income tends to be taxable.

Bonds are no exception. But as an asset class, they're a particularly diverse group. And so is the way they're taxed. Some bonds are fully taxable, some partially taxable, and some not at all.

And because they generate income in a few different ways, their tax rates vary too.

Let's examine bonds and taxes in more detail.

How are bonds taxed?

Bonds and bond funds generate two different types of income: interest and capital gains.

Interest

Bonds are a type of debt instrument. When you buy a bond, you're loaning money to the government or company that issued it; in return, that entity pays you interest. Most bonds pay a fixed, predetermined rate of interest over their lifespan.

That interest income may be taxable or tax-free (more on the types of bonds that generate tax-free income later). For the most part, if the interest is taxable, you pay income taxes on that interest in the year it's received.

The rate you'll pay on bond interest is the same rate you pay on your ordinary income, such as wages or income from self-employment. There are seven tax brackets, ranging from 10% to 37%. So if you're in the 37% tax bracket, you'll pay a 37% federal income tax rate on your bond interest.

Capital gains

If you buy a bond when it's first issued and hold it until maturity - the full length of its lifespan - you generally won't recognize a capital gain or loss. The money you get back is considered a return of your principal - what you originally invested in it.

However, after they're issued, bonds often trade on financial exchanges, just like stocks. If you sell them before their maturity date on the secondary market, the bonds can generate capital gains and losses, depending on how its current price compares to your original cost. Bond funds can also generate capital gains and losses as the fund manager buys and sells securities within the fund.

So, the profit you make from selling a bond is considered a capital gain. Capital gains are taxed at different rates depending on whether they're short-term or long-term.

Short-term capital gains apply if you hold the bond for one year (365 days) or less. Then the gain is taxed at your ordinary income tax rates.

Long-term capital gains apply if you hold the bond for more than one year. Then you can benefit from reduced tax rates, ranging from 0% to 20%, depending on your filing status and total taxable income for the year.

Are all bonds taxed?

Bonds are divided into two classes: taxable and tax-exempt.

A bond's tax-exempt status applies only to the bond's interest income. Any capital gains generated from selling a bond or bond fund before its maturity date is taxable, regardless of the type of bond.

Taxable bonds

The interest income from taxable bonds is subject to federal, state (and local, if applicable) income taxes.

Taxable bonds include:

Corporate bonds
Mortgage-backed securities
Global bond funds
Diversified bond funds

Tax-exempt bonds

Municipal bonds, aka munis, are the main type of tax-exempt bonds.

Munis are issued by states, counties, cities, and other government agencies to fund major capital projects, such as building schools, hospitals, highways, and other public buildings.

Interest income from muni bonds is generally not subject to federal income taxes. It can also be exempt from state or local income taxes if your home state or city issues the bond. Interest income from muni bonds issued by another state or city is taxable on your state or local income tax return.

Fast fact: Muni bonds exempt from federal, state, and local taxes are known as "triple tax exempt."

US Treasuries, bonds issued by the US Dept. of the Treasury, and savings bonds are also tax-exempt - to a degree. If you own them, you owe federal income tax on them. However, they are generally free from state and local income taxes.

Zero-coupon bonds

Zero-coupon bonds are a special case. You might have to pay tax on their interest income - even though you don't actually receive any interest.

With a zero-coupon bond, you buy the bond at a discount from its face value, don't receive interest payments during the bond's term, and are paid the bond's face amount when it matures.

For example, you might pay $3,000 to buy a 20-year zero-coupon bond with a face value of $10,000. After 20 years, the issuer pays you $10,000. The difference between the amount you pay for a zero-coupon bond and the face amount you receive later is considered "imputed interest."

That interest may be taxable or tax-exempt, depending on whether the bond was issued by the US Treasury (the most common type), a corporation, or a state or local government agency.

If the interest is taxable, the IRS treats the prorated imputed interest as if it were paid annually, even though you don't actually receive any interest payments. This results in paying tax on "phantom income" each year.

How can I avoid paying taxes on bonds?

Here are a few strategies for avoiding - or at least reducing - the taxes you pay on bonds.

Hold the bond in a tax-advantaged account. When you invest in bonds within a Roth IRA or Roth 401(k), the returns are tax-free, as long as you follow the withdrawal rules. Bond income and profits from sales earned within a traditional IRA or 401(k) are tax-deferred, meaning you don't pay taxes until you withdraw the money in retirement.
Use savings bonds for educational purposes. Consider using Series EE or Series I savings bonds to save for education. When you redeem the bond, the interest paid is tax-exempt as long as you use the money to pay for qualified higher education expenses and meet other qualifications.
Hold bonds until maturity. Holding a bond until maturity, instead of selling it early on the secondary market can help you avoid paying taxes on capital gains. However, you still owe tax on any taxable interest generated by the bond while you owned it.

The financial takeaway

Minimizing the tax consequences of bonds comes down to investing in tax-exempt bonds, such as muni bonds and US Treasuries, and using tax-advantaged accounts where your money can grow on a tax-free or tax-deferred basis.

If you invest in bonds outside of tax-advantaged accounts, you'll receive a Form 1099 from the bank or brokerage holding your investments around January 31 of each year. Hold on to these forms, as you'll need them to report bond interest and capital gains on your tax return. The IRS also gets a copy of those 1099s.

If you miss reporting any income, they'll be sure to let you know.