How to Use Bonds to Reduce Taxable Income
Taxes are always a big consideration for traders when they look at potential investments. Tax-free bonds may look good to some investors, but to others the lower interest rates won't be worth the tax breaks. Smart investors know how to use bonds to reduce taxable income legally and efficiently, year after year.
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Instructions
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Use a bond swap to reduce your taxable income. This technique involves selling one bond at a loss before it matures and immediately reinvesting the money in another bond. The difference between what you paid for the bond and what you made from the sale will be subtracted from your total taxable income.
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Invest in federal bonds that aren't taxable. Interest earned from bonds in agencies like the U.S. Post Office, Treasury bonds and Federal Land Banks is often tax-free. Be sure to check with a certified public accountant to see which federal bonds are exempt from taxes in the state where you live.
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Buy municipal bonds to avoid paying federal taxes. These bonds are a direct investment in a city or town and are used to fund things like public schools, fire departments and municipal projects. Spending money on these bonds will reduce taxable income at the federal level and possibly at the state level too.
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Ask your C.P.A. if bonds in mutual funds that invest in state and federal organizations are tax-exempt in your state. If the mutual fund only partially invests in government groups, than sometimes only a fraction of your gains on these bonds will be tax-free. Your C.P.A. or broker should be able to suggest a few mutual funds that invest in government works.
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Donate your bonds after you've held them for 1 year. When you donate a bond, you can often take a tax deduction for the value of the principal and also avoid paying taxes on the interest you've made since you bought the bond. Securities you've held for less than 1 year are considered short-term investments and can't be used to reduce taxable income this way.
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Hold onto your investments and limit sales each year. Every time you sell a bond, you'll have to pay taxes on the capital gains. Try to balance your portfolio to include short-, middle- and long-term bonds and have no more than one bond maturing each year.
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Tips & Warnings
If you don't want to use a bond swap, you can sell a bond that has increased in value at the same time you sell a bond that has lost in value. You use the losses to reduce the net taxable gains. This method is called "bond harvesting."
