Every year you are required to pay taxes on any earnings from investment income. For example, if you have a savings account that accrues $2,000 in interest you will have to add that amount to your taxable income and will be required to pay taxes on it. There are certain investments which are tax free, these investments do not require you to pay tax on any interest or additional income from these investments. Local and state government bonds are great for investors as they allow investing without having to pay taxes on returns.

Government and companies use bonds as one of the biggest ways to raise capital. Purchasing a bond is like making a loan to the government or company for a specific amount of time. The agency who issues your bond makes interest payments determined by the rates when your bond was issued. This rate is referred to as the coupon rate, it also agrees to cover the face value of the bone when the time period expires. Generally interest payments you receive are taxable, although there are certain bonds which are tax free.

Municipal Bonds

These bonds are used by different departments of government on local, city and state levels. Water and sewer companies, as well as bodies that govern roadways use these bond to bring in money to fun different projects related to community improvement. Sewer systems, roadways, schools, and even hospitals will often use the sale of municipal bonds to fund projects.

In efforts to help small governments raise funds for projects, interest earned on municipal bonds are often exempt from federal taxes. If you purchase a bond and live in the state or locality issuing the bond you are also exempt from local and state taxes.

If you sell municipal bonds for profit it will result in a capital gain, and will be subject to state and federal taxes for the amount of profit. Generally investors in municipal bonds make money off the interest payment as opposed to capital gains, so it very unlikely that a municipal bond would be taxed.

Federal Bonds

The Federal government borrows money in a number of ways, some of the borrowing is done through the issuing of bonds. There are two types of bonds that the federal government issues; long term Treasury bonds and short term Treasure bills and notes. Any interest earned by federal bonds are taxable by the federal government, but usually not by state or local governments. Typically interest payments on both types of bonds are made two times a year or every six months, you are required to report these earnings on your income tax the year it was earned.