If you own bonds that pay taxable interest, you must include these payments in your gross income. Your broker will send you Form 1099-INT detailing your taxable and tax-free interest for the year that just passed. The Internal Revenue Service classifies bond interest as ordinary income, which means your tax bill depends on your marginal tax rate -- the tax on the “last dollar” of your annual income. Bonds at premium or discount have additional tax effects.
The annual interest on a bond is the stated interest rate times the face value. For example, a 5 percent bond with a $1,000 face value shells out $50 a year in interest. The face value is the amount that the issuer will repay when the bond matures. Form 1099-INT has separate boxes reporting taxable and tax-free income. Municipal bonds and certain other instruments are exempt from federal income tax. You must report this income on Form 1040, but it won’t add to your taxable income. If you have multiple brokers, calculate your gross interest by adding the figures from each 1099-INT. Report bond interest on Form 1040. Under certain conditions, such as receiving over $1,500 of taxable interest income, you must also file Schedule B.
A discount bond has a purchase price below its face value. The discount on a taxable bond is taxable interest. If you buy a discount bond from the issuer, the bond has original issue discount, and your broker will send you Form 1099-OID, disclosing the amount you must recognize in your gross income. You don’t pay tax on OID from tax-free bonds. If you acquire a discount bond from a source other than the issuer, such as the bond exchange, it’s a market discount bond. You can choose to fork over the tax on the market discount each year, or you can opt to pay it all when you sell the bond or the bond matures. The market discount on a tax-free bond is taxable income.
You buy a premium bond for more than its face value. If the bond pays taxable interest, you can reduce your interest income by “amortizing” the premium. In this procedure, divide the premium amount by the number of years until maturity. The result is your annual amortization amount, which you can deduct from your gross income. You can instead avoid amortization and take a tax deduction for the premium amount when you sell the bond at maturity. You must amortize tax-free bonds but cannot deduct this amount.
Bonds typically pay interest semi-annually. Unless you happen to purchase a bond on the day it pays interest, you're on the hook for “accrued interest.” This is the interest that the bond has earned since it last paid interest. The accrued interest you buy belongs to the seller, who must include it in her taxable income -- if the bond is not tax-free. In return for the accrued interest you buy, you receive the full interest amount on the next payment date. When you report your interest income for the year, subtract the accrued interest you paid on any bonds you bought during the year.
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