Investing in bonds is a good way to generate extra income without taking on the added risk of the stock market. But while you do stand to make money by buying bonds, you should be aware that in some cases, you'll lose a portion of your earnings to taxes. The interest you receive from corporate bonds is always taxable. Furthermore, while savings bonds and government-issued Treasury bonds are exempt from state and local taxes, they are taxable at the federal level. Then there are municipal bonds, which are always federal tax-exempt but sometimes subject to state and local taxes. Understanding how bond interest is taxed can help you choose the right investments.


Paying taxes on bond interest

Whenever you make money, the IRS likes to get a piece of the action, and bond interest is no exception. Generally speaking, the only way to completely avoid paying taxes on bond interest is to buy municipal bonds issued by your home state. If you buy municipal bonds issued by another state, you'll avoid federal taxes, but you'll be subject to state and local taxes that apply.

Treasury bonds and savings bonds work the opposite way -- you'll avoid state and local taxes but pay federal taxes on your interest. That said, if you use your savings bonds to pay for higher education costs, you may be eligible to avoid federal income taxes. This exception applies to eligible Series EE and I Bonds issued after 1989, and you'll need to meet certain criteria to snag that interest tax-free. For example, your bonds must be used to cover qualified expenses, and your expenses must be incurred during the same tax year you redeem your bonds.

Corporate bonds, meanwhile, offer zero opportunity to avoid taxes. Corporate bonds typically pay interest twice a year, and you're required to report that interest as income on your return.

Weighing your pros and cons

You have several options for investing in bonds, each of which comes with its own set of benefits and drawbacks. Treasury bonds, for example, are considered virtually risk-free, which means you don't have to worry about losing your principal investment. On the other hand, treasury bond yields are much lower than those of corporate bonds, and on a tax-adjusted basis, municipal bonds have yielded 25%-30% more than Treasury bonds over time. Throw in the fact that Treasury bond interest is taxable at the federal level, and your opportunity to profit is somewhat limited.

Corporate bonds, on the other hand, typically offer the highest yields, but because their interest is taxable, you'll lose a portion of what you make right off the bat. The amount you ultimately pay will depend on your tax rate, but if you make $1,000 in bond interest over the course of a year but typically lose 25% of your income to taxes, you'll end up with just $750. Keep in mind that unlike your paycheck, those taxes won't be taken out automatically; you'll receive your interest payments in full, but you'll need to pay taxes on them when you file your return.

If you're worried about taxes, you might consider municipal bonds as a reasonable middle ground. Municipal bonds are triple tax-exempt provided you buy bonds issued by your home state, and while their yields are traditionally lower than those of corporate bonds, you get the opportunity to bank all of your interest income instead of losing a portion to taxes.

Of course, in some cases, it might make more sense to pay taxes on corporate bond interest than collect a lower amount of municipal bond interest tax-free. To see which scenario will better benefit you, you can use our handy online tool to calculate your tax-equivalent yield.

Finally, don't forget the risk factor when choosing between bonds. Corporate bonds typically offer the highest yields but come with the highest risks. Municipal bonds, meanwhile, are 50 to 100 times less likely to default than comparably rated corporate bonds. As is the case with all investments, you'll need to consider not just the tax implications when buying bonds, but the extent to which you might lose money if things end up going sour.