Tax Treatment of GNMA Bonds

Tax Treatment of GNMA Bonds
••• Creatas/Creatas/Getty Images

Government National Mortgage Association bonds have plenty of appeal for safety-conscious investors. The primary benefit is a federal government guarantee for payments combined with a higher yield than from Treasury bonds. Monthly checks and relative stability of principal add to the benefits. However, GNMA "Ginnie Mae" bonds provide nothing in the way of tax benefits.

Fully Taxable Interest

The interest you earn from a GNMA bond is fully taxable. You must claim the interest and pay taxes at both the federal and state levels. In this respect, GNMA bonds differ from Treasury securities. Interest earned from a Treasury bond is taxable at the federal level, but exempt from state income taxes. The fact that taxes must be paid on GNMA bond interest is one reason why the bonds carry a higher yield than Treasuries.

Breakdown of Payments

Ginnie Mae bonds are mortgage pass-through securities. The monthly payments from a GNMA bond come from the monthly payments on a pool of government-guaranteed home mortgages. Just as a monthly mortgage payment consist of interest and repayment of principal, the payments from a pass-through bond consist of both interest and principal. Only the interest you receive from a GNMA bond is taxable income -- the returning principal is not taxable. The 1099 from your broker will break out interest and principal repayments for any GNMA bonds you own.

Taxable Equivalent Yield

You can compare the yields on GNMA bonds and Treasury bonds by calculating the taxable equivalent yield of the Treasury security. Divide the Treasury bond yield by 1 minus your state income tax rate. For example, if the Treasury yield is 3 percent and your state tax rate is 8 percent, the math is 3 divided by 0.92 -- one minus 0.08 -- which equals 3.26 percent. To be a more attractive investment, a Ginnie Mae bond should yield more than the calculated taxable equivalent yield.

Potential IRA Investment

Since the interest earned from a GNMA bond is fully taxable, one way to modify the tax consequences is to buy these bonds in your IRA account. Interest earned in an IRA is tax-deferred. Also, holding a Ginnie Mae bond in an IRA eliminates the need to accurately separate principal and interest payments. All of the payments going into an IRA have the same nature for tax purposes.