## What is 'Imputed Interest'?

Imputed interest is used by the Internal Revenue Service (IRS) as a means of collecting tax revenues on loans or securities that pay little or no interest. Imputed interest is important for discount bonds, such as zero-coupon bonds, and other securities that are sold below face value and mature at par. The IRS uses an accretive method when calculating the imputed interest on Treasury bonds and has Applicable Federal Rates (AFR) that set a minimum interest rate in relation to imputed interest and original issue discount rules.

Next Up

## BREAKING DOWN 'Imputed Interest'

Imputed interest may apply to loans among family and friends. For example, a mother loans her son \$50,000 with no interest charges. The applicable short-term federal rate is 2%. The son should be paying his mother \$1,000 annually (\$50,000 x .02 = \$1,000.) The Internal Revenue Service (IRS) assumes the mother collects this amount from her son and lists it on her tax return as interest income even though she did not collect the funds.

## Applicable Federal Rates

Because many low-interest or interest-free loans were being transacted and not being taxed, the IRS established Applicable Federal Rates (AFR) through the Tax Act of 1984. The AFR determines the lowest interest that may be charged on loans below a specific interest rate threshold and considers the amount of potential income generated from the interest rate as imputed income. Because of the creation of AFR, the IRS may collect tax revenue from loans that otherwise are not taxed.

## Calculating Imputed Interest on a Zero-Coupon Bond

When calculating imputed interest on a zero-coupon bond, an investor first determines the bond’s yield to maturity (YTM). Assuming the accrual period is one year, the investor divides the face value of the bond by the price paid when it was purchased. The investor then increases the value by a power equal to one divided by the number of accrual periods before the bond matures. The investor reduces the number by one and multiplies by the number of accrual periods in one year to determine the zero-coupon bond’s YTM.

Because the adjusted purchase price of a zero-coupon bond is initially equal to its purchase price when issued, the accrued interest gained over each accrual period adds to the adjusted purchase price. The accrued interest is the initial adjusted purchase price multiplied by the YTM. This value is the imputed interest for the period.

## An Example of Imputed Interest

Imputed interest is important for determining pension payouts. For example, when an employee retires from a company in which the employee was a member of a pension plan, the company may offer the retiree a lump sum of the \$500,000 set aside for him under the plan, or he may receive \$5,000 a year in benefits. Assuming the applicable short-term federal rate is 2%, the retiree needs to determine whether a better imputed interest rate could be found in another market by taking the lump sum and purchasing an annuity that provides greater income.

RELATED TERMS
1. ### Dividend Imputation

An arrangement that eliminates or reduces the taxation of cash ...
2. ### Taxable Bond

A taxable bond is a debt security whose return to the investor ...
3. ### Current Yield

The current yield is calculated by dividing an investment's, ...
4. ### Discount Bond

A discount bond is a bond that is issued for less than its par ...
5. ### Accrued Interest

Accrued interest is debt interest that has not yet been collected. ...
6. ### Effective Interest Method

The practice of accounting for the discount at which a bond is ...
Related Articles
1. Investing

### All about zero coupon bonds

Learn everything you always wanted to know about these debt instruments, which pay no interest until maturity.
2. Personal Finance

### To Lend or Not to Lend: That Is the Question

When lending money to a family member, set up an agreement to protect your money and relationship.
3. Investing

### Savings Bonds For Income And Safety

Bonds offer undeniable benefits to investors, including safety and tax advantages.
4. Investing

### Understanding Interest Rates, Inflation And Bonds

Get to know the relationships that determine a bond's price and its payout.
5. Investing

### How Interest Rates Affect Mutual Funds

Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
6. Investing

### How To Choose The Right Bond For You

Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
7. Insights

### How the Federal Reserve Affects Individual Investors

The Federal Reserve's decision on interest rates affects the whole economy.
RELATED FAQS
1. ### How does an investor make money on bonds?

Bonds are part of fixed-income securities called debt obligations, meaning one party borrows from another party who expects ... Read Answer >>
2. ### Why do interest rates have an inverse relationship with bond prices?

At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer ... Read Answer >>
3. ### What is the effective interest method of amortization?

Find out more about the rationale and advantages of the effective interest rate method and how it is used to amortize a discounted ... Read Answer >>
Hot Definitions
1. ### Gross Margin

A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
2. ### Inflation

Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
3. ### Discount Rate

Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
4. ### Economies of Scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
5. ### Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
6. ### Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...