Corporate bonds are attractive because they can provide some steady income and a high yield -- but you sacrifice a little safety for that largesse. Treasury bonds are free from default risk, but pay the least. Corporate bonds can have a little or a lot of default risk -- their credit ratings tell the story. Anything below the highest three or four grades is called high yield -- or, less politely, junk. High-yield bonds pay more interest, so naturally you’ll pay more tax.
Plain Old Interest
You’ll get one or more IRS 1099-INT forms to remind you of how much taxable interest you received the previous year. Most corporate bonds pay plain old interest, which is taxed at your marginal tax rate. If you had wanted tax-free interest, you would have purchased municipal bonds. Since you bought corporates, you’re on the hook for federal, state and local taxes. If by chance any of your corporate bonds went belly-up, you’ll be able to deduct the loss for the year in which the default took place.
The corporate zeros referenced here are not the people you work for. Rather, the term refers to zero coupon bonds, which are issued by corporations and governments to postpone interest payments. Zero coupon bonds are issued at a large discount and pay face value at maturity. Zeros pay no interest until they mature, at which time you receive all the interest as part of the face value. But Uncle Sam taxes the interest that a zero would have paid had it paid periodic interest. This is called “phantom” interest -- and you must pay it each year. You receive notice of your phantom interest via IRS Form 1099-OID. Zeros are frequently sheltered in tax-deferred individual retirement accounts to avoid phantom interest tax payments.
Short-Term Corporate Bonds
Short-term bonds have maturities of less than one year from issuance. Corporate short-term bonds are often issued as zero coupons, but they don't require the elaborate tax reporting used for longer-term zeros. These bonds are issued at a discount and pay face value at maturity, but the interest is reported to you just like regular bond income, on Form 1099-INT. Tax on the interest is incurred in the year that the bond matures.
If you earned net income of at least $200,000 as an individual or $250,000 as a married couple, congratulations! You'll be slapped with a 3.8 percent Medicare tax to commemorate your earning prowess. The tax is calculated on the lesser of two figures. The first is investment income, which stems from dividends, annuities, royalties, rents, capital gains and, you guessed it, interest. The other important figure is that portion of your “modified adjusted gross income” -- MAGI -- above the thresholds. Consult the IRS Web page “Questions and Answers for the Additional Medicare Tax” for all the details.