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Taxable bonds are those bonds in which taxes are owed on the money earned from the investment. This is often called the yield. These bonds are in contrast to tax-free bonds, where no tax is owed on any of the earnings. There are advantages and disadvantages to taxable bonds, and each investor must carefully consider their situation before choosing one over the other. The tax charged on any taxable bonds will likely be in the form of an income tax.
When buying taxable bonds, the investor is providing a loan to a corporation or government entity. Those who hold such bonds have no ownership stake in the company, but will receive regular payments on the outstanding debt until it is paid off. Investors often consider these bonds good options because they know that even in the case of poor company performance, the bonds will provide a return on the investment. Should a company experience financial difficulty and be required to liquidate, bond holders will be among the first to get money from the liquidation.
The vast majority of bonds on the market are taxable, including all corporate bonds. Some municipal bonds, state bonds, and other governmental bonds may also be subject to taxes, even though they are traditionally thought of as being tax free. The standard of whether the bond is tax free or not often depends on whether the project being funded is for an essential public purpose. Taxable bonds issued by governments may fund recreational or quality of life projects. These are considered desirable by the government but not essential for the public welfare.
Determining whether an investor is better off buying taxable bonds or tax-free bonds depends on a number of complex factors and may require the help of a professional. Taxable bonds have higher interest rates than tax-free bonds, but that is offset, at least partially, by the fact taxes will be owed on the return. Therefore, it is important to consider how much of a difference there is in interest rates, what tax bracket the investor is in, and how tax policy and rates are expected to change in the future.
A statement of earnings on taxable bonds will be sent to the investor each year. This information must be given to the investor's tax preparer for inclusion in the investor's tax return. Failure to report this information could result in significant penalties for the investor, who may be subject to paying back taxes and even criminal penalties.
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