The payment of income tax is a reality. And when Uncle Sam says income, he is talking about all the money you make, whether it's from your job or your investment. This includes interest income - money generated by bank or brokerage accounts and certain assets, such as bonds or mutual funds.
With a few exceptions, most investment interest is taxable income. You must report it on your return and give a share to the government via taxes.
Therefore, it helps to know a little more about your tax account's impact on interest income.
What is interest income?
Most interest incomes are subject to federal and state taxes. This includes interest you earn on:
Certificates of deposit (CD)
Corporate bonds
Current account and savings account
Interest income from pass-through companies, such as partnerships or S Corps.
Loans to third parties
Money market accounts
Mutual funds / ETFs
US Treasury bills and savings bonds.
Are there some tax-free interest income?
Only one main asset type generates non-taxable interest income: municipal bonds ("munis" for short) and private equity bonds. States, counties, cities issue them, and other government agencies to fund large capital projects, such as building public hospitals and schools, roads, power plants, and other municipal buildings.
All municipal bonds, as well as municipal bond funds, are exempt from federal taxes. If the bond is issued in its home state, the interest income it provides is also exempt from state and local taxes.
In short, non-taxable federal, state, and municipal bonds are referred to as "triple tax-free" bonds.
You will also get a small reduction in US Treasuries and Savings Bonds. You pay federal income tax, but these are exempt from state and local income tax.
What is the tax rate on interest income?
Interest income does not have a special tax rate, like investment income, also known as long-term capital gains. Pay interest as if it were normal income, that is, at the same rate as other income, such as wages or self-employment income.
Therefore, if you are eligible for the 24% tax, you will also pay 24% tax on interest income.
For fiscal years 2020 and 2021, there are seven tax brackets:
Interest income may also be subject to another tax called the net investment income tax (NIIT). NIIT is a 3.8% tax for the lesser of:
Adjusted value of modified gross income of over $200,000 for singles and head of household, $250,000 for couples filing together, and $125,000 for couples filing separately.
Net investment income, which is generally all investment income (including interest, dividends, capital gains, income distributions, income from liabilities, rents, and royalties) fewer investment expenses
How do you report interest income on your tax return?
By January 31 of each year, you should receive Form 1099-INT from any bank, broker, or another source of interest income showing interest earned on your investments during the previous year.
In several cases, it's easy to take the numbers on the 1099-INT form and transfer them to the proper location in your tax preparation or return software. The boxes you need to pay close attention to are 1, 3, and 8.
Boxes 1 and 3 of 1099-INT show regular income from taxable interest and taxable interest on capitalization bonds and US treasury bills. Box 8 shows the non-taxable interest.
Other boxes on Form 1099-INT, such as those required to withdraw money from a CD before maturity, appear in box 2. You can deduct these penalties as an income adjustment in Schedule 1 to Form 1040. If federal or state income taxes have been withheld, it would be shown on Boxes 4 and 15-17. You can add this amount to other payments, such as withholding from wages or estimated quarterly tax payments. Investment expenses are shown in Box 5.
Most people can no longer deduct capital expenditures because the TCJA, 2017 eliminated the ability to deduct them for the 2018-2025 fiscal years. If you paid tax on the foreign interest received, the amount paid and the country in which you paid the tax would appear in boxes 6 and 7. Use this information to calculate your external tax credit. The specific interest of the private activity bond is presented in Box 8. Private activity bonds are a type of municipal bond designed to finance private projects with a public benefit, such as affordable rental housing.
Interest income on private securities is generally not taxable but is necessary to calculate the alternative minimum tax.
Boxes 10 to 13 deal with market deductions and bond premiums. These scenarios can occur when you buy single security for less than or more than its face value. If you buy updated security, you must include a portion of the rebate each year as taxable interest. If you bought the security at a premium, you could deduct a portion of the premium each year.
Where is the taxable interest income that is reported on the tax return?
If you received more than $1,500 in interest or taxable dividends during the year, please report all interest and dividend income in Schedule B attached to Form 1040. If your income has not reached this limit, you don't need to fill it—report taxable interest and non-taxable interest on lines 2a and 2b of Form 1040.
The 1099-INT forms must contain all the necessary information. However, they may not be complete. Banks and brokers only need to submit a form if they have paid you an interest rate greater than $10 during the year. Therefore, if you earned $5 in interest from a savings account, it is still taxable.
So it's a good idea to follow up, as you need to report all return interest income, regardless of size. If you have multiple accounts in multiple locations, you can add them up.
Bottom Line
Regardless of the source, most of the interest earned on your savings and investments is considered taxable income. It is taxed at the same rate as normal income, based on its normal tax category for that year.
To avoid interest income tax, just look for certain exempt assets, mostly US government and municipal bonds, and use tax-efficient accounts, where the money is earned tax-free or at least deferred.
Financial institutions that maintain their accounts submit annual interest income returns, called Form 1099. So follow them and report all income from your investment. The IRS receives copies of all your 1099s, so they will know if you leave anything out.
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