Bond Taxation

Understanding bond taxation is crucial to the organization of your portfolio. Bonds without tax advantages will inherit them from tax reduced accounts, which typically are retirement oriented. Adding bonds with inherent tax advantages waste space since taxes are already reduced and the benefits usually do not stack. Keep bonds with taxation benefits in your normally taxed portfolios. Save tax-advantaged accounts for bonds and investments without tax-exclusions or advantages. As an example, municipal bonds within the United States are excluded from federal taxation and should not be placed in tax-advantaged accounts.

Bond Taxation, Capital Gains, & Income Tax

You also need to be aware that capital gains are not usually encountered on individual bonds unless actively traded. Capital gains most often occur when you purchase a bond at issue and sell for profit on the secondary market. If you hold onto maturity, you won’t incur capital gains taxes, since interest income from bonds is usually, but not always, categorized as income tax. Check your local taxation regulations to see how your investments are taxed and avoid surprises.

Tax Advantaged Accounts

Corporate or Sovereign bonds that have no tax exemption should be placed within tax advantaged accounts, especially at higher yields. Your accounts without tax advantages will hold any bonds with tax-advantages first. Always advise your financial planner, advisor, or broker before placing bonds in either category of account.

You must beware of when you withdraw funds from your tax-advantaged accounts. Many of your tax advantages are conditionally based on time. You often will lose tax reduction or exemption if you withdraw funds or earnings before a certain age. Within the United States, a withdrawal from a 401k, IRA, or SEP account before the age of 59 and one-half will result in an additional 10% taxation penalty. This gives the government the taxation that was missed due to your exemption. After certain ages, for these accounts 70 and a half, you must forcibly tax distributions from these accounts or incur taxation penalties.

Foreign Bonds

Always research the taxation status of foreign bonds and international bond funds before purchase. Differing governments handle taxation from foreign bonds differently. Foreign bonds sometimes will have their taxation reduced or exempted by a local government, or will be repaid in a tax-advantaged account. This varies by the nation and is a question worth asking your broker, agent, planner, financial advisor, or tax preparer.