Bonds (also known as debt securities, bills, or notes) are like I.O.U.s from a corporation or government agency. You lend them money for a specific duration ― at least a year, and generally no more than 30 years ― with a specified rate of interest. You collect the interest as the bond matures, and then you collect the principal (your initial investment) when the bond comes due.
Although bonds can be a great investment, they are unfortunately subject to many taxes. On your savings bonds, you will typically have to pay inheritance tax, estate tax, and gift tax at the federal and/or local level.
There are several financial strategies that you can employ to avoid paying unnecessary taxes on your investment. For more detailed information about these taxes, see the Internal Revenue Code (IRC), which upholds U.S. tax law and includes the federal investment taxes that apply to bonds.
On U.S. Government Savings Bonds, the interest income is exempt from state and local taxes. Additionally, your interest income is not subject to federal taxation until you redeem the bond or the bond is fully mature. This can make government bonds an attractive investment for individuals concerned about high taxes.
Or, you may want to make an investment in Municipal Bonds, which are not subject to state or local taxes as long as you buy them within your state. Municipal bonds are issued by local governments and other civic agencies, such as school districts and publicly-owned airports. Municipal bonds generate lower amounts of interest than most corporate bonds, but they are also less likely to lose value. Some types of municipal bond investments include the following:
- General Obligation Bonds (which the issuer has promised to repay)
- Assessment Bonds (which are based on local property tax values)
- Revenue Bonds (which derive their value from a stream of income, such as local taxes, and may not be repaid if that income falls short)
You may also want to consider making an investment in Inflation-Adjusted Savings Bonds (also called “I Bonds”). The Education Savings Bond Program allows qualified taxpayers to deduct all or part of the interest earned on their I Bonds (issued after 1989) as long as the interest was used to pay for qualified higher education expenses. Eligible taxpayers may also deduct interest from Series EE Bonds, which are government bonds guaranteed to double in value during their lifetime. To qualify for these tax deductions, you must have been at least 24 years old as of the 1st day of the month in which you bought the bond, and the educational institution must meet the standards for federal assistance. Note that you may deduct expenses related to tuition and education fees, but not room and board.
Finally, you may be able to claim an interest deduction for debt that is incurred to purchase or carry investments, which includes bonds. You cannot, however, use this deduction for bonds that are not subject to federal income tax because that would result in a double benefit on your taxes (also called the Interest Disallowance Rule).