Points to know
- Bonds issued by federal governments may be exempt from state and local taxes.
- Bonds issued by state or local governments may be exempt from federal, state, or local taxes.
Taxes
How government bonds are taxed
Whether they're issued at the federal, state, or local level, all government bonds have some sort of tax exemption.
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Taxation of federal government bonds
Income from bonds issued by the federal government and its agencies, including Treasury securities, is generally exempt from state and local taxes.
If you own a bond mutual fund or ETF (exchange-traded fund), you'll need to calculate the amount of income you earned from the fund's government bond holdings (if any) in order to take advantage of this exemption when you file your taxes—it won't be reflected on the tax forms issued by your investment company.
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Bond
A loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.
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Mutual fund
A type of investment that pools shareholder money and invests it in a variety of securities. Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they're professionally managed.
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ETF (exchange-traded fund)
A type of investment with characteristics of both mutual funds and individual stocks. ETFs are professionally managed and typically diversified, like mutual funds, but they can be bought and sold at any point during the trading day using straightforward or sophisticated strategies.
Taxation of municipal bonds
Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes.* You will, however, have to report this income when filing your taxes.
Municipal bond income is also usually free from state tax in the state where the bond was issued. However, keep in mind that:
- Some states do tax interest on their own bonds.
- Some states don't tax interest on municipal bonds from any state.
- Sometimes a state that usually taxes interest on municipal bonds will exempt specific bonds at the time it issues them.
Depending on the laws where you live, income from municipal bonds also may be exempt from local taxes. Talk to a tax advisor for more information about the rules in your state.
Private activity bonds
Private activity bonds are municipal bonds that are issued to raise money for a private project (as opposed to a project for the good of the public). These bonds are exempt from federal taxes under the regular income tax system, but subject to tax under the alternative minimum tax system.
If you invest in municipal bonds through a bond fund, income from private activity bonds, if any, will be reported to you in Box 11 of your 1099-DIV.
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Taxes
The Medicare surtax on investment income
If you're a high earner, an additional tax could apply to your investment income.
*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. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
Investments in bonds are subject to interest rate, credit, and inflation risk.
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