Like most investments, a bond can earn investors money in two ways: through fixed interest payments when an investor holds onto it over a period of time — or by selling it at a higher price than when they first bought it. Unfortunately, like most investments, bonds are also subject to capital gains taxes.
Bonds generate two different types of income: interest and capital gains.
Bonds are a type of debt security. When you buy a bond, you're loaning money to the government or company that issued it. That entity can leverage that money to bolster returns and pays you back in the form of periodic interest payments and a return of principal once the bond matures. Most bonds pay a fixed, predetermined rate of interest over their lifespan usually in semiannual or annual intervals.
That interest income may be taxable or tax-free (more on the types of bonds that generate tax-free income later). For the most part, if the interest is taxable, you pay income taxes on that interest in the year it's received.
The rate you'll pay on bond interest is the same rate you pay on your ordinary income, such as wages or income from self-employment. There are seven tax brackets, ranging from 10% to 37%. So if you're in the 37% tax bracket, you'll pay a 37% federal income tax rate on your bond interest.
2022 Tax Brackets
Filed in 2023
Tax Rate | Single | Head of Household | Married Filing Jointly | Married Filing Separately |
10% | Up to $10,275 | Up to $14,650 | Up to $20,550 | Up to $10,275 |
12% | $10,276-$41,755 | $14,651-$55,900 | $20,551-$83,550 | $10,276-$41,775 |
22% | $41,756-$89,075 | $55,901-$89,050 | $83,551-$178,150 | $41,776-$89,075 |
24% | $89,076-$170,050 | $89,051-$170,050 | $178,151-$340,100 | $89,076-$170,050 |
32% | $170,051-$215,950 | $170,051-$215,950 | $340,101-$431,900 | $170,051-$215,950 |
35% | $215,951-$539,900 | $215,951-$539,900 | $431,901-$647,850 | $215,951-$323,925 |
37% | $539,901+ | $539,901+ | $647,851+ | $323,926+ |
2021 Tax Brackets
Filed in 2022
Tax Rate | Single | Head of Household | Married Filing Jointly | Married Filing Separately |
10% | Up to $9,950 | Up to $14,200 | Up to $19,900 | Up to $9,950 |
12% | $9,951-$40,525 | $14,201-$54,200 | $19,901-$81,050 | $9,951-$40,525 |
22% | $40,526-$86,375 | $54,201-$86,350 | $81,051-$172,750 | $40,526-$86,375 |
24% | $86,376-$164,925 | $86,351-$164,900 | $172,751-$329,850 | $86,376-$164,925 |
32% | $164,926-$209,425 | $164,901-$209,400 | $329,851-$418,850 | $164,926-$209,425 |
35% | $209,426-$523,600 | $209,401-$523,600 | $418,851-$623,300 | $209,426-$314,150 |
37% | $523,601+ | $523,601+ | $623,301+ | $314,151+ |
If you buy a bond when it's first issued and hold it until maturity — the full length of its lifespan — you generally won't recognize a capital gain or loss. The money you get back is considered a return of your principal — what you originally invested in it.
However, after they're issued, bonds often trade on financial exchanges, just like stocks. If you sell them before their maturity date on the secondary market, the bonds can generate capital gains and losses, depending on how its current price compares to your original cost. 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.
Short-term capital gains apply if you hold the bond for one year (365 days) or less. Then the gain is taxed at your ordinary income tax rates.
Long-term capital gains apply if you hold the bond for more than one year. Then you can benefit from reduced tax rates, ranging from 0% to 20%, depending on your filing status and total taxable income for the year.
Long-term capital gains tax rates by income
Year | Tax Rate | Single | Married Filing Jointly | Married Filing Separately | Head of Household |
2022 | 0% | Up to $41,675 | Up to $83,350 | Up to $41,675 | Up to $55,800 |
15% | $41,676-$459,750 | $83,351-$517,200 | $41,676-$258,600 | $55,801-$488,500 | |
20% | $459,751+ | $517,201+ | $285,601+ | $488,501+ | |
2021 | 0% | Up to $40,400 | Up to $80,800 | Up to $40,400 | Up to $54,100 |
15% | $40,401-$445,850 | $80,801-$501,600 | $40,401-$445,850 | $54,101-$473,500 | |
20% | $445,851+ | $501,601+ | $445,851+ | $473,501+ |
Bonds are divided into two classes: taxable and tax-exempt.
A bond's tax-exempt status applies only to the bond's interest income. Any capital gains generated from selling a bond or bond fund before its maturity date is taxable, regardless of the type of bond.
The interest income from taxable bonds is subject to federal, state (and local, if applicable) income taxes. Though interest on these bonds are taxable, they often offer higher returns — albeit at a higher risk.
Taxable bonds include:
Savings bonds and treasury bonds, US Treasuries, bonds issued by the US Department of the Treasury, are subject to federal income tax. However, they are generally free from state and local income taxes.
Municipal bonds, also known as munis, are the main type of tax-exempt bonds.
Munis are issued by states, counties, cities, and other government agencies to fund major capital projects, such as building schools, hospitals, highways, and other public buildings.
Any interest income from muni bonds is generally not subject to federal income tax. It can also be exempt from state or local income taxes if your home state or city issues the bond. Interest income from muni bonds issued by another state or city is taxable on your state or local income tax return.
Here are a few strategies for avoiding – or at least reducing – the taxes you pay on bonds.
Minimizing the tax consequences of bonds comes down to investing in tax-exempt bonds, such as muni bonds and US Treasuries, and using tax-advantaged accounts where your money can grow on a tax-free or tax-deferred basis.
If you invest in bonds outside of tax-advantaged accounts, you'll receive a Form 1099 from the bank or brokerage holding your investments around January 31 of each year. Hold on to these forms, as you'll need them to report bond interest and capital gains on your tax return. The IRS also gets a copy of those 1099s.
If you miss reporting any income, they'll be sure to let you know.