What Is Interest Income?
Income is any money that someone earns in exchange for providing a good or service. Income can also be received by making investments with capital. As such, it can be generated from many different sources, such as from an employer, through tips from customers, and by earning capital gains, dividends, and interest from investments.
Most governments require individuals to report and pay taxes on any income they receive each year. This means that taxes must be paid by investors who receive interest income from their bonds, mutual funds, certificate of deposits (CDs), and demand deposit accounts.
Some types of interest are fully taxable, while other forms are partially taxable. But how do you know which one is which? This article will break down the different types of interest and how each kind is taxed, as well as which forms you need to correctly report them.
- Interest on bonds, mutual funds, CDs, and demand deposits of $10 or more is taxable.
- Taxable interest is taxed just like ordinary income.
- Payors must file Form 1099-INT and send a copy to the recipient by January 31 each year.
- Make sure you understand your Form 1099-INT in order to report the figures properly.
- Interest income must be documented on B on Form 1040 of the tax return.
Types of Interest Income
Interest is a key part of the lending and investing industries. Lenders charge borrowers interest for using their capital in the form of debt, such as loans and mortgages. The money these lenders earn in interest is referred to as interest income.
Investors put their money into different investment vehicles in order to generate a return, usually in the form of interest. This is referred to as interest income. As noted above, interest income is derived from a variety of sources. The following are the main types of interest income that an investor can earn:
- Interest from CDs
- Corporate bonds
- Government agency securities
- Treasury bonds
- Treasury notes
- Treasury bills (T-bills)
- Checking accounts
- Savings accounts
- Interest-bearing accounts
Money market fund distributions are generally reported as dividends, not interest.
How Is Taxable Interest Taxed?
Regular taxable interest is taxed as ordinary income, just like an individual retirement account (IRA) or retirement plan distribution. This means interest income is added to the taxpayer’s other ordinary income. This combined total is used to calculate the taxpayer's top marginal tax rate. This rule applies for interest that is both fully taxable at all levels and also for interest that is taxable only at the federal level.
Special circumstances apply to the interest income earned through certain investments. For instance, certain U.S. government obligations are taxable at the federal level only. Municipal bond interest is exempt from taxation of any kind unless the alternative minimum tax (AMT) applies.
Understanding Form 1099-INT
Any payer of investment income must issue a Form 1099-INT to all recipients. Keep in mind that banks and investment firms must send out the form for interest over $10 to the recipient by January 31 every year.
This form shows the amount and type of interest paid during the year. The 1099-INT form has several different boxes that list various types of interest income. The following is a brief list of the kind of income reported in each box:
- Box 1 (Interest Income): The amount of regular interest paid from fully taxable instruments such as corporate bonds, mutual funds, CDs, and demand deposit accounts.
- Box 2 (Early Withdrawal Penalty): The total amount of early withdrawal penalties from CDs or other securities you paid during the year. This amount is considered an above-the-line deduction on 1040.
- Box 3 (Interest on U.S. Savings Bonds and Treasury Obligations): This number goes on a different line on Schedule B because it is only taxable at the federal level. The income in this box is separate from the income in Box 1.
- Box 4 (Federal Income Tax Withheld): The total amount of backup withholding on your interest income. Most interest payers must withhold tax at a 24% rate if the investor either fails to provide their tax ID or Social Security number (SSN) or provided an incorrect number. This number is added to the amount of withholding from your employer on 1040.
- Box 5 (Investment Expenses): The total amount of deductible expenses relating to your investment income from a single-class real estate mortgage investment conduits (REMIC).
- Box 6 (Foreign Tax Paid): Any tax on your interest income paid to a foreign country. If the foreign country has a tax treaty with the United States, this tax is usually either a deduction or a tax credit.
- Box 7 (Foreign Country or U.S. Possession): The foreign entity to which the tax in Box 6 was paid.
- Box 8 (Tax-Exempt Interest): Any interest exempt from all levels of tax for any reason, including tax-free dividends from mutual funds or other regulated investment companies. This figure is reported on line 2a of 1040.
- Box 9 (Specified Private Activity Bond Interest): This box reflects the tax-exempt interest that is subject to AMT. This amount is also included in Box 8.
There are many more rules pertaining to interest income that lie beyond the scope of this article. Be sure to consult a professional if you have any questions or are generally unsure about taxation procedures and rules.
Taxpayers may also receive Form 1099-OID for taxable interest. Form 1099-OID reports original issue discount instruments; if a taxable bond or other debt instrument was issued at a discount, part of the original issue discount may be included each year as interest income. A Form 1099-OID is issued to taxpayers who have taxable original issue discounts of $10 or more each year.
Taxpayers may also be named as a nominee recipient for taxes. You may receive a Form 1099 for interest in your name that belongs to someone else. The IRS has a special set of instructions for reporting this income as part of Schedule B to Form 1040. You must also prepare a 1099 form to remit to the IRS unless the nomination came from a spouse.
Which Form Do I Use?
If you use an accountant who prepares and files your taxes for you, you can breathe a sigh of relief. That's because they'll do all the work for you so you can skip this section. The same goes if you use a tax preparation program or software. Once you input all the data from your forms (1099-INT, W2s, and others), the program automatically transfers it to your Form 1040. This is the standard Internal Revenue Service (IRS) form all individual taxpayers file every year.
If you still use paper forms to complete your taxes, this section is for you. Each payer of interest issues a separate 1099-INT to its investors so make sure you have them all together when you file. If you don't, you may have to make amendments to your return if there's a big discrepancy.
Investors report all of the interest income received for the year on Part 1 of Schedule B: Interest and Ordinary Dividends of 1040. Any investor who receives a Form 1099-INT must be able to transcribe the information correctly on Schedule B of their tax return or IRS Form 1040.
Tax-Exempt Interest Income
There's several types of tax-exempt interest income, though some types may have stipulations based on a taxpayer's income. Should a taxpayer's income be too high, the taxpayer may be subject to otherwise exempt taxes.
Interest earned on certain types of municipal bonds, such as bonds issued by state and local governments, is generally exempt from tax. In some cases, the interest may be exempt at the federal, state, and local level.
Interest earned on certain types of U.S. savings bonds, such as Series EE and Series I bonds, is exempt from state and local income taxes. It may also be partially or fully exempt from federal income tax depending on the taxpayer's income level. Other government bonds such as Series HH bonds and Treasury Inflation-Protected Securities (TIPS) may also be tax-exempt.
Taxpayers may make interest on certain educational accounts. Interest earned on 529 plans or Coverdell Education Savings Accounts is usually exempt from federal taxes. The primary stipulation here is the funds must have been used for qualified education expenses.
Money held in retirement accounts such as traditional or Roth IRAs or 401(k)s are usually tax-exempt until funds are withdrawn. Should an investor decide to hold securities within these tax deferred accounts, they may be able to avoid taxes until retirement or until contributions are withdrawn.
Taxpayers must report taxable and non-taxable income on their tax return, even if they did not receive the appropriate 1099 forms.
Taxable Interest vs. Taxable Dividends
Interest income is generally taxed as ordinary income and is subject to the same tax rates as wages and salaries. Dividend income, however, is subject to different tax rates depending on the type of dividend and the taxpayer's income level. For example, certain types of qualified dividends may be subject to long-term capital gains rates based on the taxpayer's income level and length of holding.
Another large difference between the tax treatment of interest and dividends is that dividends are paid out of a company's after-tax income. Meanwhile, interest is paid out of pre-tax income. This means that companies that pay dividends face double-taxation: once on their profits and again on the dividends they pay to shareholders. Alternatively, interest payments are tax-deductible for companies and more favorable as they can often be used to lower their overall tax liability.
Where Do You Find Taxable Interest on Your W2?
Taxable interest appears on Form 1099-INT. Box 1 of the form has all the interest income earned from the issuer. If there is something in Box 3, this figure only applies to interest inputted on your federal tax return.
What Is the Tax Rate on Interest Income?
The taxable rate on any interest income you earn depends on the tax bracket in which you fall. So if your income puts you into the 22% tax bracket, your interest income is also taxed at this rate.
Do You Have to Report Interest Income From a Personal Loan?
Personal loans generally don't count as income, which means you don't have to report any interest you earn to the IRS.
How Do I Report Interest Without a Form 1099-INT?
You must report any interest income earned even if you don't receive a form. Remember, you get a Form 1099-INT for interest income above $10. Be sure you call your issuer or you can go through your statements to get the interest income you earned during the year. If you have access to your account online, you can usually get a copy of your form there. Keep in mind, the issuer does send a copy to the IRS so just because you didn't get one doesn't take you off the hook from reporting it.
The Bottom Line
Investors put their money away for a number of reasons. Some do it to keep their money safe while others have a more lucrative reason in mind: to generate a return. This return may come in the form of a dividend, capital gain, or interest. Regardless of what form it takes, this is all counted as income. This means you must report it along with any other income sources during the tax year. If you have investments that pay you interest, be on the lookout for a Form 1099-INT from your financial institutions or investment firms after the end of January. This shows you how much interest you earned and what you need to report to the IRS.