A smart investor keeps track of accrued income on various financial instruments, as it can have tax implications at the end of the year. If you prefer to offset taxes with charitable donations, then calculating accrued income on bonds is a necessity. This will also help you to determine if a particular bond is a good investment. The interest rate is not obvious when you purchase bonds at a discount.
A bond is a financial instrument between two parties. The corporation or government entity issuing the bond is the bond issuer. The individual or investment firm purchasing the bond is the bondholder. Some bonds sell at par, or face value, and pay a fixed rate of interest until the bond matures or the issuer calls it in. Other bonds sell at a discount to par are redeemed at face value at maturity. The difference between the purchase price and face value is interest.
Accrued income is interest that a bond has already earned, but the bond issuer has not yet made payment. For example, assume you purchase a $10,000 bond at a 20 percent discount to par from your local school board, with a 10-year maturity. You paid $8,000 for the bond and it will earn $2,000 interest during a 10-year period. You will earn interest every year on the bond but not receive any money until you redeem it. This unpaid interest is accrued income until the bond issuer pays you. Technically, you earn income during one taxable period, but receive it in a future taxable period.
To calculate accrued income on a bond purchased at par, multiply the bond amount by the interest rate to arrive at the amount of lifetime interest. Then divide this amount by the length of time that you have owned the bond. To calculate accrued income on a bond purchased at discount, subtract the purchase price from the face value to ascertain the amount of interest. Then complete the calculation the same as a face value purchase by dividing the amount of interest by the length of time you have owned the bond.
You might have to pay state or federal tax on accrued income, even though you have technically not received the funds. Some states tax on all assets, and a bond purchased last year has greater value this year. If you plan to invest a significant amount of money in this type of financial instrument, consult with a tax attorney to find out which type of bonds are best for your situation.
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