Most all retirees, as well as many still working and saving, utilize bonds in their portfolios. As a bondholder, you act as a lendor – the company or government not only promises to return your money, but to also pay you a stated rate of interest for the trouble.
If you hold bonds (or “fixed income”) in an individual investment account, meaning not a retirement/qualified account, how the bonds are taxed can make quite an impact on your actual net interest income.
Here’s a quick breakdown of how bond interest is taxed:
As you can see, different types of bonds have very different tax implications.
If you are investing in bonds within a taxable investment account, we encourage you to think about how taxes affect your interest income, particularly since interest income is taxed at your income level – not a special rate like some qualified dividends.
For instance, if your federal tax rate is 20%, your net yield on a 5% bond will actually only be 4% after tax.
Also, please remember that owning municipal bonds solely for tax reasons within a tax deferred account (IRA, 401k, etc) may not be as beneficial as you think – these accounts are already tax incentivised, which means you miss out on the key benefit of the municipal bonds: the tax free interest.