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. Even dividends receive special tax treatment.
Taxing SituationBonds 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.
GuidelinesThese are the general guidelines for bonds and taxes. 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 stability and income.
There is a quick and dirty way to look at how a municipal bond compares with a stock on an after-tax basis (which, after all, is the only basis that matters).
Do the MathTo compute the taxable equivalent of a municipal bond’s return, use this formula:
Figure your marginal tax rate (what you pay on the next dollar of income) and subtract it from the number 1. Then divide a muni yield by the result to get the taxable equivalent.
For example, if you were in the 28 percent tax bracket and considering a muni with a yield of 2.8% the calculation would look like this:
0.028 / (1 – 0.28) = 3.89%
This muni would give you the same effective return as a taxable security paying about 3.89 percent. If you add in state and local taxes, it could push your taxable equivalent return even higher.