Tax free interest must still be reported on your tax return.
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The major benefit of investing in municipal bonds is that the interest earned from the bonds is exempt from income tax. If you purchase a bond at a premium, the premium amount will eventually be lost when the bond matures at face value. The trade-off for paying that premium is higher interest earnings. For municipal bond investments, you must report a portion of the premium paid along with the interest earned each year on your income tax return.
Develop a system to calculate and track the annual premium amortization of your municipal bond. The amount of amortization must be calculated using the constant yield method. This calculation produces an amortization amount for each interest payment -- usually twice a year -- and changes with each interest payment period. You need to keep track of the amount of amortization reported each year
and the total amount not yet amortized. Your broker may be able to provide the annual amortization results or you can find and download a spreadsheet template which will calculate the amortization schedule.
Copy or find the amount of interest earned for the year from the municipal bond. You will receive an IRS Form 1099-INT from the bond issuer showing how much tax-free interest you were paid for the year.
Subtract the calculated premium amortization for the year from the tax-free interest earned for the year. From a bookkeeping point of view, the bond premium amortization reduces the amount of interest earned. Since the interest is tax exempt, there is no effect on your income tax bill.
Enter the result of the interest minus amortization calculation on line 8b of your Form 1040, U.S. Individual Income Tax Return. Even though municipal bond interest is tax exempt, you still must report how much tax-free interest you earned on your income tax return.