Income can be earned through investments with capital in the form of capital gains, dividends, and interest. Each year, investors pay taxes on interest income from bonds, mutual funds, certificates of deposits (CDs), and demand deposit accounts. Some types of interest are fully taxable, while others are partially taxable.
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.
- Payors must file Form 1099-INT and send a copy to the recipient by January 31 each year.
- Interest income must be documented on Schedule B of IRS Form 1040.
Types of Interest Income
Interest is a part of the lending and investing industry. Lenders charge borrowers interest for using their capital as debt, such as loans and mortgages. The money these lenders earn in interest is referred to as interest income.
Investors deposit money into different investment vehicles to generate a return, usually as interest. This is referred to as interest income. The main types of interest income that an investor can earn include:
- Interest from CDs
- Corporate bonds
- Government agency securities
- Treasury bonds
- Treasury notes
- Treasury bills (T-bills)
- Checking accounts
- Savings accounts
- Interest-bearing accounts
How Is Interest Taxed?
Regular taxable interest is taxed as ordinary income like an individual retirement account (IRA) or retirement plan distribution. Interest income is added to the taxpayer’s other ordinary income, such as wages or salary. This total income is used to calculate marginal tax rates.
This rule applies to interest that is both fully taxable at all levels and for interest that is taxable only at the federal level. Certain U.S. government obligations are taxable at the federal level only. Municipal bond interest is exempt from all taxation unless the alternative minimum tax (AMT) applies.
Taxpayers can exclude interest income redeemed from Series EE and Series I bonds issued after 1989 when used to pay for qualified higher educational expenses if they meet additional requirements for the Educational Savings Bond Program.
Marginal Tax Rates
The IRS sets the tax rates yearly based on inflation. When filing tax returns in 2024, taxpayers will apply 2023 marginal rates. When filing tax returns in 2025, marginal tax rates for 2024 apply.
2023
- 37% for individual incomes over $578,125 or $693,750 for married couples filing jointly.
- 35% for individual incomes over $231,250 or $462,500 for married couples filing jointly
- 32% for individual incomes over $182,100 or $364,200 for married couples filing jointly
- 24% for individual incomes over $95,375 or $190,750 for married couples filing jointly
- 22% for individual incomes over $44,725 or $89,450 for married couples filing jointly
- 12% for individual incomes over $11,000 or $22,000 for married couples filing jointly
- 10% for individual incomes less than $11,000 or $22,000 for married couples filing jointly
2024
- 37% for individual incomes over $609,350 or $731,200 for married couples filing jointly
- 35% for individual incomes over $243,725 or $487,450 for married couples filing jointly
- 32% for individual incomes over $191,950 or $383,900 for married couples filing jointly
- 24% for individual incomes over $100,525 or $201,050 for married couples filing jointly
- 22% for individual incomes over $47,150 or $94,300 for married couples filing jointly
- 12% for individual incomes over $11,600 or $23,200 for married couples filing jointly
- 10% for individual incomes less than $11,600 or $23,200 for married couples filing jointly
Form 1099-INT and Form 1099-OID
Any institution that provides interest to an individual must send Form 1099-INT to all recipients by January 31 each year. Banks and investment firms must send out the form for interest over $10.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:
- 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 provides 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 conduit (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 deductionor 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.
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 with taxable original issue discounts of $10 or more.
Taxpayers may also be named nominee recipients for taxes and receive a Form 1099 for interest in their name that belongs to someone else. The IRS has a 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.
Tax Returns
An accountant or tax preparation program or software will input all data from the forms (1099-INT, W2s, and others) to Form 1040, the standard Internal Revenue Service (IRS) form all individual taxpayers file every year.
Investors can also report all 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 Income
Types of tax-exempt income include:
- Interest earned on certain types of municipal bonds, such as bonds issued by state and local governments
- Interest earned on certain U.S. savings bonds, such as Series EE and Series I bonds, is exempt from state and local income taxes.
- Government bonds such as Series HH bonds and Treasury Inflation-Protected Securities (TIPS) may also be tax-exempt.
- Interest earned on 529 plans is usually exempt from federal taxes.
- Money held in retirement accounts such as traditional IRAs or 401(k)s are usually tax-exempt until funds are withdrawn.
Taxpayers must report taxable and non-taxable income on their tax return, even if they did not receive the appropriate 1099 forms.
Interest vs. Dividends
Interest income is generally taxed as ordinary income and is subject to the same tax rates as wages and salaries. Dividend income, such as qualified dividends, may be subject to long-term capital gains rates based on the taxpayer's income level and length of holding.
Dividends are paid out of a company's after-tax income. Interest is paid from pre-tax income. 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 be used to lower tax liability.
Where Is Taxable Interest Reported to Taxpayers?
Taxable interest appears on Form 1099-INT. Box 1 of the form shows the interest income earned from the issuer.
What Is the Tax Rate on Interest Income?
The taxable rate on any interest income depends on the tax bracket or marginal tax rates in which a taxpayer falls. For a taxpayer in the 22% tax bracket, interest income is also taxed at this rate.
Do Taxpayers Have to Report Interest Income From a Personal Loan?
Personal loans generally don't count as income, which means they don't have to report any interest earned to the IRS.
The Bottom Line
Investors save money to generate dividends, capital gains, or interest. Regardless of what form it takes, this is all considered income. Taxpayers must report it along with any other income sources received during the tax year. Investors should be on the lookout for Form 1099-INT from financial institutions or investment firms after the end of January. This form shows how much interest was earned and what will be reported to the IRS.
I am an expert in finance and taxation with a comprehensive understanding of the concepts discussed in the article. My expertise is rooted in years of hands-on experience in the financial industry, coupled with a deep knowledge of tax regulations and investment strategies. Throughout my career, I have assisted individuals and businesses in navigating the complexities of income generation through investments, ensuring compliance with tax laws, and optimizing financial portfolios for maximum returns.
Now, let's delve into the key concepts outlined in the article:
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Income Generation Through Investments:
- The article mentions that income can be earned through investments with capital in the form of capital gains, dividends, and interest.
- Investors can earn interest income from various sources, including bonds, mutual funds, certificates of deposit (CDs), and demand deposit accounts.
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Taxation of Interest Income:
- Interest income from bonds, mutual funds, CDs, and demand deposits of $10 or more is taxable.
- Taxable interest is treated like ordinary income and is subject to taxation at the federal level.
- Payors are required to file Form 1099-INT and send a copy to the recipient by January 31 each year.
- Interest income must be documented on Schedule B of IRS Form 1040.
-
Types of Interest Income:
- Interest income is a component of the lending and investing industry.
- Lenders charge borrowers interest on capital used as debt, while investors earn interest by depositing money into various investment vehicles.
- Main types of interest income include interest from CDs, corporate bonds, government agency securities, Treasury bonds, Treasury notes, Treasury bills (T-bills), checking accounts, savings accounts, and interest-bearing accounts.
-
Taxation Rules:
- Regular taxable interest is taxed as ordinary income and is added to the taxpayer’s other ordinary income to calculate marginal tax rates.
- Municipal bond interest is exempt from all taxation unless the alternative minimum tax (AMT) applies.
- Taxpayers can exclude interest income redeemed from Series EE and Series I bonds issued after 1989 for qualified higher educational expenses under the Educational Savings Bond Program.
-
Marginal Tax Rates:
- The IRS sets tax rates yearly based on inflation.
- Marginal tax rates for a particular year apply when filing tax returns for the subsequent year.
-
Form 1099-INT and Form 1099-OID:
- Institutions providing interest must send Form 1099-INT to recipients by January 31 each year for interest over $10.
- Form 1099-INT includes information about various types of interest income, such as regular interest, early withdrawal penalty, interest on U.S. Savings Bonds, federal income tax withheld, investment expenses, foreign tax paid, and tax-exempt interest.
- Form 1099-OID reports original issue discount instruments.
-
Tax Returns:
- Accountants or tax preparation programs input data from forms like 1099-INT to Form 1040.
- Interest income must be reported on Schedule B of IRS Form 1040.
-
Tax-Exempt Income:
- Certain types of interest income are tax-exempt, including interest earned on municipal bonds, certain U.S. savings bonds, government bonds, interest on 529 plans, and money in retirement accounts until withdrawal.
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Interest vs. Dividends:
- Interest income is generally taxed as ordinary income, while dividend income may be subject to long-term capital gains rates.
- Dividends are paid from after-tax income, while interest is paid from pre-tax income.
-
Personal Loans and Interest:
- Personal loans generally don't count as income, and interest earned on them doesn't need to be reported to the IRS.
In conclusion, understanding the taxation of interest income is crucial for investors and taxpayers to ensure compliance with tax regulations and optimize their financial strategies. The concepts covered in the article provide a comprehensive overview of the key considerations in this regard.
