How to Pay Taxes on Bonds

Through bond market investing, it is possible to add tens of thousands of dollars in wealth to your bottom line over the course of a lifetime. Taxes on your bond market investments, however, will slow the wealth creation process. On individual bonds, you will owe taxes on both interest payments and realized capital gains. To report and pay taxes on your bond investments to the IRS, you must first identify the correct paperwork.

Tax Paperwork

At tax season, your brokerage will prepare and submit 1099 forms to both the IRS and your address on record. You will compare the 1099 forms to your monthly brokerage statements to summarize your bond market activity, in terms of interest payments and realized capital gains. With this information, you will complete Schedule D and Form 1040 to detail your bond market investments to the IRS.

Taxes on Interest Income

You will record bond interest as taxable interest income on your 1040. Bond interest income is subject to ordinary income tax rates. For the 2010 tax year, ordinary income is taxed at 10, 15, 25, 28, 33, and 35 percent rates. The U.S. tax code is progressive, which means that you will pay taxes at higher rates when you make more money. As a single filer, your bond interest income will be taxed at a 35 percent rate, if you report taxable income of at least $373,650.

Taxes on Realized Capital Gains

You will owe taxes on realized capital gains, when you sell bonds at a profit. For tax purposes, realized capital gains are classified as either short or long-term capital gains. Short-term capital gains are taxed as ordinary income, while long-term capital gains are either tax-free or taxed at maximum 15 percent rates. For long-term capital gains, you must hold bonds for more than one year, before selling them off.

You will complete Schedule D to report your realized capital gains to the IRS. Realized capital gains subtract away cost basis from your sales proceeds, and take brokerage commissions into account. For example, you may trade bonds through an online broker at $10 per trade. In January, you invested $1,000 into Bond X, which translates into a $1,010 cost basis ($1000 + $10 commission = $1,010). Later that year, you sold Bond X for $1,100, or sales proceeds of $1,090 ($1,100 - $10 commissions = $1,090).

Bond Market Losses

If your bond investments fail to perform, you can write off $3,000 worth of realized capital losses from your taxes. Losses that exceed the $3,000 limit can be carried forward and written off in subsequent years. Be advised that the IRS prohibits wash sales, for the sake of taking a tax deduction. A wash sale would occur when you sell a bond and immediately buy back the same bond within the next 30 days.

Investment Strategy

When trading bonds, your ultimate goal remains to make the most amount of money for the least amount of risk. A proper balance of risks versus rewards does not always translate into a minimal tax bill. For example, you should not purposefully hold onto a losing bond investment for the sole purpose of taking a tax write off.

How to Pay Taxes on Bonds, Sources:

SEC: Bonds

IRS: Investment Income and Expenses

IRS: Interest Received

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