TAX-DEFERRAL FEATURES

The interest income on some bonds is either free of federal tax or can be deferred from tax until the bond matures.

Most municipal bonds (bonds issued by cities and states) pay interest that is federally tax-free. This feature makes them popular as bond investments. Although the interest income is tax-free, you will have to pay tax on any capital gains when you sell a municipal bond. If a municipal bond is issued at a discount, however, the difference between the discount and the face value is considered interest income.

Some bonds have a tax-deferral option. These bonds are sold at discounts. As they move toward maturity, the bondholder can pay taxes on the yearly increases in their value. However, the investor can defer paying income tax until the bonds mature. With the Series EE bond (a type of savings bond), he or she may even defer it longer than this if he or she exchanges the bond at maturity for a Series HH bond, another type of savings bond.

Now let's look at interest and yields.