There are many different types of bonds, but they all share common principles. If you are considering bonds as part of your investment plan, be sure to do your homework. There are three main types of bonds:
- Municipal bonds
- Corporate bonds
- Government bonds
These are issued by state and local governments or their agencies to pay for public improvements, reduce debt, or other public purposes. If you buy bonds issued by your home state, you will not have to pay a state income tax or federal income tax (or city tax, if you have one). If you buy bonds issued by another state, you will not have to pay a federal tax, but you will pay a tax to your own state (and city if applicable).
These are issued by corporations that want to raise money for their business ventures, ranging from balancing their cash flow to buying new equipment, building new facilities, or spending on new research.
Interest earned from corporate bonds is taxable, so corporate bonds tend to pay higher rates than government or municipal bonds, which have some tax benefits. Corporate bonds are often considered appropriate investments for the bond portion of your retirement plan investments because you get the higher interest and still aren't taxed until the earnings are withdrawn. Municipal or government bonds will pay you less interest and already offer a tax benefit, so they offer less incentive to include them in your retirement portfolio.
Government bonds are those issued by the federal government or one of its agencies. From a credit perspective, these are the safest of all investments because they're backed by the "full faith and credit" of the U.S. government; so unless the U.S. goes bankrupt, you're guaranteed to get your money back. Common types of U.S. government bonds include Treasuries and savings bonds.
Treasury bills, notes, and bonds are collectively called "Treasuries."
- Treasury bills (T-bills). These are short-term securities that mature in a year or less. You buy them at a discount price, and at the end of the term, you're repaid the full price. The difference is what constitutes your earnings. These earnings are exempt from local and state income taxes, but must be reported on your federal tax return.
- Treasury notes (T-notes).These are issued for the intermediate term, such as two years up to 10 years. Expect to earn a little higher interest rate than what you could get from a T-bill. Interest is paid every six months. Earnings are exempt from local and state income taxes but must be reported on your federal tax return. You can sell your Treasury note before it matures if you so wish.
- Treasury bonds. These are issued for the long term, generally from 10 to 30 years. Expect to earn a higher interest rate than what you could get from a T-note. Interest is paid every six months. Earnings are exempt from local and state income taxes but must be reported on your federal tax return. You can sell your Treasury bond before it matures if you so wish.
Savings bonds are government bonds that are designed especially for individual investors. As such, they can generally only be redeemed by the original owners (except in limited circumstances). Savings bonds include:
- I Bonds.These are savings bonds that help protect against inflation. They pay a fixed interest rate combined with a variable interest rate that's updated twice a year based on the current inflation rate.
- EE Bonds. Series EE savings bonds issued on or after May 1, 2005, earn a fixed rate of interest. They increase in value every month instead of every six months. Interest is compounded semiannually. If you cash them in before owning them for five years, you will be penalized the last three months of interest. Interest earned on EE bonds is exempt from state and local income taxes. You can defer federal income tax until you redeem the bonds, which will stop earning interest after 30 years. Since interest isn't taxed until you redeem a bond, your savings grow faster. EE bonds can also assist you with tax planning, as you have the flexibility to redeem the bonds on your own terms.
- HH bonds. HH bonds also earn a fixed rate of interest. Unlike EE bonds, HH bonds pay interest every six months until maturity or redemption, whichever comes first. The U.S. Treasury discontinued the HH series of bonds in 2004, but it will continue to honor outstanding HH bonds still held by investors.
AARP’s Money Matters Tip Sheet on Investing in Bonds has more information and action steps.
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