What is the capital gain when a Treasury note matures if it was purchased at a discount on the secondary market?

[Baron62]

Hello Everyone,

I'm relatively new to the site, but I have been watching and learning. My wife and I are recently retired with no taxable income other than interest income we are getting from treasures and ROTH conversions to fill the 12% tax bracket. When I met with my Fidelity representative, he saw that we had $30K+ in Treasury interest income that we have to pay taxes on annually. He suggested that I move some of the taxable account into Deferred Fixed Annuities that will produce Capital Gains instead which don't get taxed when gains are below $94K. This sounds like a good option that I am researching as long as I can avoid fees and treat it like a deferred CD.

My question is that if I bought low interest rate treasury notes on the secondary market at a discount and hold to maturity would the difference between price paid and par be all capital gains? I know I would still have to pay income taxes on the low interest rate income. Does any de minimus rule apply here as I have seen with municipal bonds?

For example: Buy a 5 year treasury with a 1% coupon at $920 each and then at maturity get par value of $1000. Would this this be a $80 capital gain at maturity year? If yes, then buying deeply discounted treasuries would be a lower tax solution for people with low incomes.

Thanks for your help,
Phil

 

[jazz4cash]

Hello Everyone,

I'm relatively new to the site, but I have been watching and learning. My wife and I are recently retired with no taxable income other than interest income we are getting from treasures and ROTH conversions to fill the 12% tax bracket. When I met with my Fidelity representative, he saw that we had $30K+ in Treasury interest income that we have to pay taxes on annually. He suggested that I move some of the taxable account into Deferred Fixed Annuities that will produce Capital Gains instead which don't get taxed when gains are below $94K. This sounds like a good option that I am researching as long as I can avoid fees and treat it like a deferred CD.

My question is that if I bought low interest rate treasury notes on the secondary market at a discount and hold to maturity would the difference between price paid and par be all capital gains? I know I would still have to pay income taxes on the low interest rate income. Does any de minimus rule apply here as I have seen with municipal bonds?

For example: Buy a 5 year treasury with a 1% coupon at $920 each and then at maturity get par value of $1000. Would this this be a $80 capital gain at maturity year? If yes, then buying deeply discounted treasuries would be a lower tax solution for people with low incomes.

Thanks for your help,
Phil

The bolded part does not sound right to me. Here is what google says

Annuities — Similar to qualified retirement plans, annuities grow without being subject to capital gains taxes and aren't taxed until funds are withdrawn (annuity withdrawals are taxed at ordinary income tax rates, not at capital gains tax rates)

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As for your question about discounted bonds it depends on how far below par you purchase. Look up the de minimus rule for bonds.

 

[engineernerd]

I'm pretty sure neither annuities nor bonds are capital-gains-producing assets. They are purely interest-bearing. In your example, you'd have to report your $80 as interest, not capital gains.

 

[Koolau]

I'm pretty sure neither annuities nor bonds are capital-gains-producing assets. They are purely interest-bearing. In your example, you'd have to report your $80 as interest, not capital gains.

That's my understanding but I'm no expert so YMMV.

 

[Hamster]

I know less than nothing about annuities and only slightly more than that about treasury bonds, but I think the idea of paying capital gains on a bond needs more discussion. If I buy a bond for $100 today and sell it tomorrow for $110 the $10 profit is a short-term capital gain, isn't it? It's certainly not interest. So bonds can produce capital gains.

But what would really be helpful would be to see how the OP's brokerage is reporting the pay-out. That's probably the right answer.

 

[ut2sua]

For example: Buy a 5 year treasury with a 1% coupon at $920 each and then at maturity get par value of $1000. Would this this be a $80 capital gain at maturity year? If yes, then buying deeply discounted treasuries would be a lower tax solution for people with low incomes.

Thanks for your help,
Phil

I believe all gain in this case will be treated as interest. Fidelity will report the gain as interest on your 1099 in the year the T matures. The IRS doesn't want folks to have "guaranteed" capital gain, so they came up with this "exception". I am not a tax professional so please verify.

 

[ut2sua]

If I buy a bond for $100 today and sell it tomorrow for $110 the $10 profit is a short-term capital gain, isn't it?

I believe in this case, your gain will be capital gain. The difference with OP's case is they bought the bond below par. If OP sell the bond above par, then the taxes will be a bit more complicated with a mixture of interest and cap gain (This is why I don't like tax codes)

 

[MichaelB]

Hello Everyone,

I'm relatively new to the site, but I have been watching and learning. My wife and I are recently retired with no taxable income other than interest income we are getting from treasures and ROTH conversions to fill the 12% tax bracket. When I met with my Fidelity representative, he saw that we had $30K+ in Treasury interest income that we have to pay taxes on annually. He suggested that I move some of the taxable account into Deferred Fixed Annuities that will produce Capital Gains instead which don't get taxed when gains are below $94K. This sounds like a good option that I am researching as long as I can avoid fees and treat it like a deferred CD.

My question is that if I bought low interest rate treasury notes on the secondary market at a discount and hold to maturity would the difference between price paid and par be all capital gains? I know I would still have to pay income taxes on the low interest rate income. Does any de minimus rule apply here as I have seen with municipal bonds?

For example: Buy a 5 year treasury with a 1% coupon at $920 each and then at maturity get par value of $1000. Would this this be a $80 capital gain at maturity year? If yes, then buying deeply discounted treasuries would be a lower tax solution for people with low incomes.

Thanks for your help,
Phil

If the bond is a Treasury or other taxable bond, the market discount is treated as interest income. You have the option of recognizing a part each year or the entire amount at maturity.

Tax free munis have a different treatment and the de minimus rules applies only to munis,

 

[TickTock]

MichaelB has it right.

From IRS Publication 550 Publication 550 (2024), Investment Income and Expenses | Internal Revenue Service Underlining in the below snip from 550 is mine.

Market Discount Bonds​

A market discount bond is any bond having market discount except:

• Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),
• Tax-exempt obligations you bought before May 1, 1993,
• U.S. savings bonds, and
• Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date. Generally, this is due to an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

• You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments, later.
• You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount. See Partial principal payments, later in this discussion.
• If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited. See Limit on interest deduction for market discount bonds, later.

 

[TickTock]

When I met with my Fidelity representative, he saw that we had $30K+ in Treasury interest income that we have to pay taxes on annually. He suggested that I move some of the taxable account into Deferred Fixed Annuities that will produce Capital Gains instead which don't get taxed when gains are below $94K.

From Kiplinger: How Are Annuity Withdrawals Taxed?

Income withdrawn from all types of deferred annuities is taxed as “ordinary income,” not long-term capital gain income. This tax treatment applies to fixed-rate, fixed-indexed, variable and income annuities.

 

[Baron62]

Thank you everyone for the responses.

It appears that buying a Treasury bond at a discount and selling it at par is considered interest income not capital gains. That answers that question.

On the deferred fixed annuity I do not plan on plan on taking early withdrawals that would be considered ordinary income. I would wait until maturity and Fidelity is telling me if I wait until maturity (3+ years) the gains are considered Capital gains. What do you think of this type of investment? My understanding is that there are no fees for this type of annuity unless one surrenders early.

 

[TickTock]

From Fidelity: Deferred Fixed Annuity | The Fidelity Insurance Network | Fidelity Fidelity

The quote below is from Frequently Asked Questions at the bottom of the article. Underlining in the quote is mine.
Deferred Fixed Annuity | The Fidelity Insurance Network | Fidelity Fidelity

• How are deferred fixed annuities taxed?
  With a deferred Fixed Annuity, you do not pay any taxes until you withdraw money from the annuity. At that time, any gains and pretax contributions are taxed as ordinary income at your current tax rate. Remember though, similar rules regarding early withdrawals of any tax-deferred account—such as an IRA—apply to annuities. Taxable amounts withdrawn before 59½ may incur a 10% IRS early-withdrawal penalty.
  
  
  I recommend going back to the person at Fidelity who is advising you that gains are taxed as capital gains, showing them that article, and asking how the two are reconciled?
  
  I've also not seen any other sources saying gains are taxed as capital gains. Note that the original amount that you put in after-tax is a return on principal when withdrawn and is not taxed.
  
  

 

[Baron62]

Thanks Tick Tock. My Fidelity advisor's assistant actually gave me this bad information. I contacted my advisor today and he confirmed that all proceeds from a deferred annuity is always taxed as interest income.

 

[TickTock]

Glad to hear it, Baron62. It's scary when the advisor is giving out bad information.