What Is Taxable Interest Income?

If you have investments through a financial institution, you're probably earning interest on those funds. The interest may be delegated to you in the form of annual dividends or folded back into the total sum of your investment. Either way, whatever those interest figures are, they are taxable. The money that you owe on any interest accrued by your investments is known as taxable interest income.

Typically, the tax rate on interest income matches that of your ordinary income. So, if you are accustomed to paying 15% on your earned income, expect to pay roughly that on your taxable interest income. However, remember that the percentage you pay on your investment income may not look like anyone else's because, like everything on your tax return, it's determined by the exemptions, deductions, credits, and number of dependents you declare. Your individual tax bracket determines how your taxable interest income is reported to the Internal Revenue Service (IRS).

This article will explain taxable interest income and review the different types of interest income and exceptions related to this kind of taxation.

Types of Interest Income

Any interest-bearing accounts, mutual funds, federal bonds, or certificates of deposit (CDs) are eligible taxable interest income. Some types of investments are only taxable at the federal level, while others are subject to federal and state taxation. The percentage rate at which interest income is taxed also varies according to multiple factors. It can be prudent and helpful to enlist organizational support from bookkeeping software, such as Skynova Accounting, to make keeping up with these kinds of details easier as the fiscal year progresses.

Bonds

Bonds are a type of debt instrument that requires fixed payments to designated holders. Bonds are not taxed in the same way, although they are considered taxable interest income.

Let's start with the most highly taxable on the bond spectrum: corporate bonds. Corporate bonds are debt securities issued by private companies. These bonds are taxed at the federal and state levels on their capital gains, discounts granted at issuance, and interest earned.

Federal bonds, also known as government bonds or Treasury bonds, enjoy exemption from state or local taxation but are always taxed at the federal level. "Ownership" of the bond plays a big role in who pays the taxes on a federal bond. As federal bonds are frequently given as gifts or inherited through estates, the bond owner may not be the same as the purchaser. This can break down in several ways:

• A person buys the bond and lists a second person as the co-owner for the bond's life. In this case, the purchaser is solely responsible for the taxes.
• A person buys the bond and lists a second person as the sole owner for the life of the bond. The owner is then responsible for the taxes.
• Two people split the purchase price of the bond proportionally. Each purchaser is responsible for the portion of the taxes proportionate to their ownership stake.

Lastly, savings bonds are taxed in a slightly more complicated way. Like federal bonds, savings bonds are usually exempt from state and local taxes but are subject to taxation at the federal level. One caveat is that you can enjoy freedom from interest taxation on eligible U.S. Series I or Series EE bonds issued after 1989 if you can prove that you're utilizing the dividends on these bonds to fund qualified higher education.

Mutual Funds

When a company pools money from multiple investors and invests that money into securities, such as stocks and bonds, this is called a mutual fund. Earnings from mutual funds are sometimes also referred to as "gains," and they are taxable. A capital gains tax will nearly always be imposed when you profit from the sale or exchange of mutual fund shares held in a taxable investment account.

If your mutual fund pays dividends, these earnings will also be subject to taxation. Generally, the amount of tax owed on a mutual fund is contingent on the combined total of all gains and losses associated with that mutual fund.

It's important to note that stock funds and bond funds are not taxed in the same manner. Stock funds are taxed on capital gains and any distributions, whether those distributions are rolled back into the mutual fund itself. Bond funds are generally taxed as ordinary income.

CDs and Interest-Bearing Accounts

Several types of interest-bearing accounts are subject to taxable interest income. Any interest you receive from these accounts amounting to $10 or more annually is taxed, but all interest received should be reported.

The interest you receive from CDs, money market accounts, and savings accounts are typically taxed at the marginal rate, which means that if your normal income tax rate is 25%, so will your taxation on these kinds of accounts. Any credits or deductions reported that offset your income will impact the amount of tax you pay on interest-bearing accounts.

What Types of Interest Income Are Not Taxable?

Most interest income becomes subject to taxes when you receive it or can access it. Keep detailed receipts on all such interest payments made to you, even if you never utilize the money during the year.

However, there are a few types of interest income that enjoy protection from taxation. Any interest you accrue in tax-deferred accounts, such as an individual retirement account (IRA) or 401(k), will not come due until you begin withdrawing from that account.

Another tax-protected option is municipal bonds, which enjoy what is called a "triple exemption." Municipal bond interest is always exempt from federal taxes, and sometimes, when issued by the state where you reside, state taxes. For these reasons, municipal bonds are a good investment for those trying to increase regular income while also lowering tax obligations.

How Much Tax Is Paid on Interest Income?

When you are completing your tax filing for a given year, your top marginal tax rate is calculated by the total of your "ordinary income." Taxable interest is lumped into this sum and taxed at whatever rate is established for your ordinary income. This rule of thumb stays in place for the interest that is taxable only at the state or local level and for investments that fall under federal income tax regulations.

Which Tax Form Do I Use?

All banks, credit unions, or financial organizations where you have taxable investments and have paid you at least $10 worth of interest over the year are responsible for issuing you Form 1099-INT each tax year. This is the form on which to report your taxable interest income. While investors don't send the 1099-INT form to the IRS, they are expected to accurately transcribe its contents into Schedule B of their official income tax return.

The 1099-INT form has five boxes containing pertinent taxable interest income information. The boxes and their correspondent contents appear as follows:

• Box 1: This includes all taxable interest you have received, even if you haven't withdrawn or touched the money, including dividend income that may not have been transferred to your bank account. This figure will be input into the "taxable interest" line of your tax return.
• Box 2: This includes interest penalties that apply to any accounts that charge you a fee for taking money out before an investment's maturity date. This figure may be listed as a deduction in the "adjusted gross income" line of your tax return.
• Box 3: This includes interest received from federal bonds, Treasury bills, or U.S. savings bonds.
• Box 4: This includes federal tax withheld on your interest income by the payer. This figure should be reported in the "payments" line of your tax return.
• Box 8: This includes all interest-bearing investments, such as municipal bonds, held with state and local governments. Even though these figures are not taxable, they still belong on the "tax exempt interest" line of your tax return for reporting purposes.

How to Maximize Your Tax Deductions

There are steps you can take to maximize your tax dollars and put them to work for you. For example, following the above advice and including all interest-bearing accounts (even those not taxable) into your "tax exempt interest" will increase the size of your tax refund or decrease the total amount of taxes you owe.

There are also strategies that taxpayers can use to invest in more tax-efficient ways and save more on taxable interest income. Form healthy investing habits, such as focusing on long-term capital gains, as securities held for more than 12 months enjoy a better tax percentage. Be mindful of distribution dates when buying or selling a mutual fund, as the owner of the fund on the day of the distribution release will be responsible for its taxes that year. Establishing a working relationship with a tax professional who can provide you with sound tax advice is also smart.

Making small adjustments in your fiscal thinking like these can result in big returns at tax time. So can employing insightful accounting software, like Skynova's all-in-one invoicing and accounting program. However, the best tax tip is always to keep financial details organized. Check out Skynova's wide range of software products and keep all of your accounts in order with less stress.