When you buy a bond that is paying interest rates larger than the markets interest rate there will be a bond premium included in your purchase price. A bond premium is how the market adjusts the price of a bond that is paying too high of an interest rate.

Record keeping can be tedious with bond premiums. You should amortize the amount of the premium throughout the life of the bond. This will allow you to allocate the bond premium over the period where the bond is paying interest and the end result is reduced bond interest. Make sure to use an effective interest rate for adjusting the bonds annual interest rate to match the bonds yield to maturity.

The bond premium can be entirely too complex for starting out so it is suggested that you simply ignore the bond premium. If you ignore the bond premium you will be overstating the interest that you earn over a period of years that you are holding the bond and pay more income tax on that bond interest during those years. When the bond matures you will be able to show capital loss on the bond that is equal to the bond premium amount that was not recorded, but you still have.

Using the strategy of ignoring bond premiums until the end of the bonds life and then counting the premium as a loss or as an adjustment to the bond interest for the final year will make your record keeping a much simpler job.

The method is legal; the IRS does allow U.S. taxpayers to ignore bond premiums for annual interest calculations. This just allows you to overstate the interest you have earned on your bond investment.

If you have a bond that pays a lower interest rate than markets you can use the bond discount. You handle a bond discount in much the same fashion as you do the bond premium.

Buying a bond at a discount means that you are supposed to allocate the discount over the life of the bond and treat it as additional bond interest. If you purchase a $500 bond and will receive $600 at maturity then the $100 profit you make is the interest amount, similar to a zero coupon bond.

Accrued interest will need to be recorded when you are dealing with a bond discount. The accrued interest amount will equal the bond discount amount that was allocated to that year. The bond discounts accrued interest is known as amortization.

The IRS requires that all U.S. tax payers to amortize their bond discounts, but there is a way around this. If you use this loop hole to your advantage then you will be able to save some record keeping time as well as money. If a bond discount has a very insignificant change in its effective interest rate it has paid you are usually allowed to skip the record keeping for the amortization of that bond discount. You can always speak to a tax advisor if you are unsure about what records you need to keep and which method will earn you the most profit.