- Interest on U.S. government bonds is taxable on your federal return, but it’s
generally exempt on your state and local returns.
- Interest on state and local government bonds is excludible on your federal return. If the state or local bonds were issued in your home state, interest also may be excludible on your state return. Warning: Private activity municipal bonds may subject you to the alternative minimum tax (AMT).
- Corporate bond interest is fully taxable for federal and state purposes.
- Bonds (except U.S. savings bonds) with original issue discount (OID) build up “interest” as they rise toward maturity. You’re generally considered to earn a
portion of that interest annually—even though the bonds don’t pay you this interest annually—and you must pay tax on it. So, these bonds may be best suited for tax-deferred vehicles, such as IRAs, or for investors with sufficient cash flow to absorb the tax.