What is the difference between taxable and tax-exempt bonds?
The interest on corporate bonds is taxable by local, state, and federal governments. However, interest on bonds issued by state and local governments (generically called municipal bonds, or munis) generally is exempt from federal income tax.
The main difference between a taxable municipal bond and a tax-exempt muni is that taxable munis pay interest income that's subject to federal and state income taxes, whereas tax-exempt munis pay interest income that's generally exempt from federal and state income taxes.
All interest income is taxable unless specifically excluded. tax-exempt interest income — interest income that is not subject to income tax. Tax-exempt interest income is earned from bonds issued by states, cities, or counties and the District of Columbia.
Investors favor municipal bonds, or "munis," for two main reasons. They are exempt from federal taxes, and they are relatively low-risk investments. While stable, income-producing bonds warrant a position in any well-diversified portfolio, there are inherent drawbacks to owning munis.
In general, tax exempt bonds pay a lower interest rate than taxable bonds because investors are willing to accept a lower before-tax return on tax exempt investments. c.No.In general, investors in lower tax brackets are better off investing in taxable bonds because their after tax return is generally higher.
Tax-Exempt Interest. Interest on a bond that is used to finance government operations generally is not taxable if the bond is issued by a state, the District of Columbia, a U.S. possession, or any of their political subdivisions.
Tax-exempt bonds are the primary mechanism through which state and local governments raise capital to finance a wide range of essential public projects.
And you typically don't have to pay taxes on your earnings until you make withdrawals in retirement. To defer taxes on CD interest until retirement, you can open a CD within a tax-deferred retirement account — whether it's an employer-sponsored plan or an IRA.
An exempt-interest dividend is a payment from a mutual fund that is not subject to federal income tax. These dividends are mainly found in municipal bonds and in the mutual funds that invest in those bonds.
You'll need to show the amount of any tax-exempt interest you received during the tax year. This doesn't convert tax-exempt interest to taxable interest.
What is the safest type of bond fund?
U.S. Treasuries are considered among the safest available investments because of the very low risk of default. Unfortunately, this also means they have among the lowest yields, even if interest income from Treasuries is generally exempt from local and state income taxes.
Interest rate risk.
U.S. interest rates have been low for some time. If they move higher, investors who hold a low fixed-rate municipal bond and try to sell it before it matures could lose money because of the lower market value of the bond.
*Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares.
Taxable Bonds may be issued to advance refund prior Tax-Exempt Bonds, and Tax-Exempt Bonds may be issued to advance refund outstanding Taxable Bonds in certain situations, under guidance provided by the IRS Office of Chief Counsel (Chief Counsel Advice Memorandum 201843009).
Given the tax benefits, the interest rate for tax-exempt municipal bonds is typically lower than that on taxable fixed-income securities, such as corporate bonds and even Treasury bonds.
They include: Selling bonds because interest rates are about to increase, making your existing bonds less valuable. Selling bonds because its issuer has become financially unstable, raising the risk that it will default on its payments. Selling bonds to take advantage of a current upswing in its market value.
Understanding Tax-Free Municipal Bonds
It's a go-to method for many municipalities to finance public projects, directly contributing to the socio-economic development of the area. Municipal bonds – or “munis” – are generally considered a lower-risk investment compared to stocks and corporate bonds.
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.
The Education Tax Exclusion
The IRS lets you avoid paying taxes on interest earned by Series EE and Series I savings bonds when you redeem them if you use the money toward qualified higher education costs for yourself, your spouse, or any of your dependents.
"Tax-exempt" means that the interest component of bond debt service payments is exempt from federal and sometimes state and local income taxes for the bond holder. Therefore, with regard to credit quality and term of the bonds, the interest rate will be lower than for a taxable bond.
How to choose between taxable and tax-exempt bonds?
In general, tax-exempt municipal bonds (munis) are more attractive to those in higher tax brackets. To compare municipal bonds to taxable bonds, you need to determine the tax-equivalent yield of the muni. Though certificates of deposit (CDs) carry less risk, municipal bonds have tended to outperform them.
Governmental bonds are issued to finance activities owned and operated by a state or local government. Some examples are: − courthouses, − highways, − governmental office buildings, AND − sewer and water facilities.
1. Early withdrawal penalty. One major drawback of a CD is that account holders can't easily access their money if an unanticipated need arises. They typically have to pay a penalty for early withdrawals, which can eat up interest and can even result in the loss of principal.
| Term Length | Average APY | Interest earned on $10,000 at maturity |
|---|---|---|
| 1 year | 2.49% | $251.86 |
| 18 months | 2.13% | $324.37 |
| 2 years | 2.04% | $416.08 |
| 3 years | 1.91% | $589.25 |
Key takeaways. Interest earned on CDs is considered taxable income by the IRS, regardless of whether the money is received in cash or reinvested. Interest earned on CDs with terms longer than one year must be reported and taxed every year, even if the CD cannot be cashed in until maturity.
