When calculating the net yield of a bond, it is important to take taxes into consideration. In the United States, investors can choose from a variety of government bonds (e.g., municipal, state, federal), each of which has unique tax exemptions. For example, profits from a U.S. treasury bond are exempt from state and local taxes. These same securities are, however, still subject to federal taxes.
Treasury Bills, Notes and Bonds
The U.S. Federal Reserve issues debt securities with a range of term lengths. Treasury bills mature within 26 weeks. Treasury notes mature anywhere between two and 10 years. Treasury bonds mature at some term between 10 and 30 years.
Treasury bonds are taxed every year by the federal government. Any interest accrued within a given tax year is treated as income for the bond holder. For example, if an investor's portfolio of treasury bonds accrued $5,000 in interest during the 2008 tax year and $2,000 during the 2009 tax year, he would file $5,000 in additional income on his 2008 tax return and $2,000 on his 2009 tax return.
Municipal and State Tax Exemptions
Interest earned on treasury bonds is exempt from annual municipal and state taxes. The rest of an investor's income, however, is still subject to these taxes. For example, if a person had a $100,000 salary and his treasury bonds earned $5,000 that same year, he would file that his gross annual income was $105,000. Subsequently, he would have to pay full federal taxes on his entire $105,000 income while only paying municipal and state taxes on $100,000 of his income.
In the United States, the majority of individuals are taxed according to a progressive system wherein annual income is divided into a series of income tax brackets. The higher one's income, the more brackets it fills. For example, once the maximum amount of eligible income is allocated to the first bracket, any remaining eligible income is allocated to the second bracket. If this remainder exceeds the second bracket maximum, that remainder is allocated to the third bracket and so on until all taxable income is properly distributed.
Each bracket is taxed at a specific, increasing rate: the first bracket has the lowest rate, the second bracket has the second-lowest rate, and so on.
The maximum amount of eligible income that can be allocated to each bracket is determined by one's filing status (single, married filing jointly, and so on).
Are The Tax Exemptions Even Worth It?
In order to reap the greatest benefit from treasury bonds, an individual needs to be in one of the top income brackets. For example, if Citizen B makes $23,000 per year in wages and $1,000 in treasury bond interest, the tax exemptions will only shield him from a single-digit tax on $1,000. In terms of net income, a better idea would be to invest in a more aggressive vehicle. Even though he will have to pay more in taxes, the after-tax net will probably be well above $1,000.
Conversely, if Citizen C makes $750,000 in salary and owns a hoard of treasury bills that accrued $150,000, the state and municipal tax exemptions could save him thousands.