Are bond dividends tax free?
The income from taxable bond funds is generally taxed at the federal and state level at ordinary income tax rates in the year it was earned. Funds that exclusively hold U.S. Treasury bonds may be exempt from state taxes.
Bonds typically pay a fixed amount of interest (usually paid twice per year). Interest from corporate bonds and U.S. Treasury bonds interest is typically taxable at the federal level. U.S. Treasuries are exempt from state and local income taxes.
Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes. In addition, interest on the bonds is exempt from State of California personal income taxes.
- Report interest each year and pay taxes on it annually.
- Defer reporting interest until you redeem the bonds or give up ownership of the bond and it's reissued or the bond is no longer earning interest because it's matured.
Interest income from Treasury bills, notes and bonds - This interest is subject to federal income tax, but is exempt from all state and local income taxes.
It is possible to achieve financial freedom by living off dividends forever. That isn't to say it's easy, but it's possible. Those starting from nothing admittedly have a hard road to retirement-enabling passive income.
Bond funds can also generate capital gains and losses as the fund manager buys and sells securities within the fund. So, the profit you make from selling a bond is considered a capital gain. Capital gains are taxed at different rates depending on whether they're short-term or long-term.
Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes.
Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income.
Corporate Bonds. Bonds used to fund local and state government projects like buildings and highways are afforded tax-exempt status at the federal level. Plus, people who purchase bonds issued by their states or localities may not be required to pay state or local taxes on the interest.
How is bond income taxed?
Interest income, which is typically paid on a semiannual basis. Whether this income is taxable will depend on the issuer. Interest from corporate bonds is generally taxable at both the federal and state levels. Interest from Treasuries is generally taxable at the federal level, but not at the state level.
If you bought the bond when it was issued at its original issue price and hold it until maturity, you generally will not recognize a capital gain (or loss). As a result, you likely won't incur any capital gains tax.
Interest earned on certain U.S. savings bonds, such as Series EE and Series I bonds, is exempt from state and local income taxes. Government bonds such as Series HH bonds and Treasury Inflation-Protected Securities (TIPS) may also be tax-exempt. Interest earned on 529 plans is usually exempt from federal taxes.
Differences between investing in CDs and T-bills
If you live in a state with income taxes, and rates are similar for CDs and T-bills, then it makes sense to go with a T-bill. The amount you save on taxes will likely result in a higher payout from a T-bill than a CD. Another benefit of T-bills is their liquidity.
Key Takeaways
Interest from Treasury bills (T-bills) is subject to federal income taxes but not state or local taxes. The interest income received in a year is recorded on Form 1099-INT.
Key takeaways. Treasury bills have short-term maturities and pay interest at maturity. Treasury notes have mid-range maturities and pay interest every 6 months. Treasury bonds have long maturities and pay interest every 6 months.
Once you have $1 million in assets, you can look seriously at living entirely off the returns of a portfolio. After all, the S&P 500 alone averages 10% returns per year. Setting aside taxes and down-year investment portfolio management, a $1 million index fund could provide $100,000 annually.
If you reinvest dividends, you can supercharge your long-term returns because of the power of compounding. Your dividends buy more shares, which increases your dividend the next time, which lets you buy even more shares, and so on.
Living off interest involves relying on what's known as passive income. This implies that your assets generate enough returns to cover your monthly income needs without the need for additional work or income sources. The ideal scenario is to use the interest and returns while preserving the core principal.
Bond ETF interest payments are taxed as ordinary income.
Though often called "dividends," these interest payments aren't considered qualified dividends by the IRS, meaning they don't get the lower, qualified dividends tax rate.
How do I avoid taxes when cashing in savings bonds?
You can report the interest each year you earn it or when you cash the bond. You will report it on Schedule B of your 1040. You can avoid these taxes by using the money for qualified higher education expenses.
In general, you must report the interest in income in the taxable year in which you redeemed the bonds to the extent you did not include the interest in income in a prior taxable year.
| From and Including | Up To But Not Including | Rate |
|---|---|---|
| 1 year - 6 months | 1 year - 10 months | 5-1/8% |
| 1 year - 10 months | 2 years - 2 months | 5% |
| 2 years - 2 months | 2 years - 6 months | 4-7/8% |
| 2 years - 6 months | 3 years - 0 months | 4-3/4% |
Capital gains yield is calculated the same way for a bond as it is for a stock: the increase in the price of the bond divided by the original price of the bond. For instance, if a bond is purchased for $100 (or par) and later rises to $120, the capital gains yield on the bond is 20%.
Understanding Qualified Dividends
A dividend is considered qualified if the shareholder has held a stock for more than 60 days in the 121-day period that began 60 days before the ex-dividend date.
