If you have bonds in your investment portfolio, bond issuers typically pay you a fixed sum of interest, called a coupon, at regular intervals. Some bonds, referred to as zero-coupon bonds, vary in that they accrue interest instead. That means the interest is added to the bond, increasing its value. The more the value of the bond grows, the more interest it earns. Some of these zero-coupon bonds feature tax-free interest.
Taxes and Tax-Free Bonds
Local and state governments borrow money by selling bonds. Commonly called municipal bonds, these securities frequently pay interest that is exempt from federal, state and local income taxes. Municipal bonds may be zero-coupon bonds. You receive a 1099-INT form each year stating the amount of bond interest you've earned. You must report this interest as income on your tax return and attach the 1099-INT. However, since the interest is tax-free, you then get to deduct it back out of your taxable income.
Interest earned on U.S. savings bonds accrues just like interest on zero-coupon bonds. You aren’t required to report interest until you cash in a savings bond. Savings bond interest normally is taxable. However, if you use the money to pay higher education expenses in the same year you redeem a savings bond, you can write the interest off on your taxes.