Instead of borrowing money from a bank, a company or municipality may elect to sell bonds to investors to help raise capital. The interest on tax-exempt bonds (those issued by a municipality) is usually not taxed at the Federal level, but it may be subject to the AMT or cause Social Security benefits to be taxed. Typically, states do not tax bonds issued within their borders, but they often tax bond earnings from other states.
Companies issue taxable bonds in a number of varieties with varying risk/return tradeoffs. Zero-coupon bonds are sold at a price far below their face value. They pay no cash interest but reinvest earnings, which compound until the bonds mature. At maturity, they are redeemed at face value.
Earnings are taxed each year, although the investor receives no cash. Bonds purchased through a tax-exempt Keogh or IRA avoid taxation until the funds are withdrawn.
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| If you may be subject to the AMT this year, avoid investing in tax-exempt bonds that generate interest income subject to the AMT. |
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