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.

Key Takeaways

  • Interest on bonds, mutual funds, CDs, and demand deposits of $10 or more is taxable.
  • Taxable interest is taxed just like ordinary income.
  • A payor must file Form 1099-INT with the IRS, and send a copy to the recipient by January 31 each year.
  • Interest income must be documented on Schedule A & B on Form 1040 of the tax return.

Types of Interest Income

The following are the main types of interest income:

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 the interest will be taxed at the taxpayer's top marginal tax rate.

For example, if a taxpayer is in the 35% tax bracket, then all of the interest income will be taxed at 35%. 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.

Which Forms Do I Use?

Any payer of investment income must issue a Form 1099-INT to all recipients, showing the amount and type of interest paid during the year. Any investor who receives a Form 1099-INT must be able to transcribe the information correctly on Schedule A & B of his tax return IRS Form 1040.

Anyone who pays interest of $10 or more must send a 1099-INT to the recipient by January 31 each 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 the 1040.

Box 3: Interest on U.S. Savings Bonds and Treasury Obligations

This number goes on a different line on the 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 his or her 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 the 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). This figure can be added to any amount in Box 2 and carried to the Schedule A as a miscellaneous investment expense.

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 8b of the 1040.

Box 9: Specified Private Activity Bond Interest

This box reflects tax-exempt interest that is subject to AMT. This amount is also included in Box 8.

Each payer of interest will issue a separate 1099-INT to its investors. Investors will report all of the interest income received for the year on Part 1 of Schedule B of the 1040.

The Bottom Line

There are many more rules pertaining to interest income that lie beyond the scope of this article. For more information, readers should consult their tax advisor.