Interest is a form of income that one earns in exchange for investing capital. As a taxpayer, you report interest income of $10 or more to the IRS and, in most circumstances, pay taxes on it. Whether the investment vehicle is a certificate of deposit (CD), a bond, mutual fund shares or a demand deposit account, in most cases, interest is taxed as ordinary income.
As a recipient of the interest income, you'll receive a Form 1099-INT from the financial institution that paid you the interest. These institutions mail Form 1099-INT on or before January 31 of each year. Retrieve the dollar amount of the interest income the institution paid from that form, and report it using Schedule B of the Form 1040 tax return. If, however, you don't receive the 1099-INT form, it's your responsibility to include all your interest earnings on Schedule B.
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Types of Taxable Interest Income
You can invest your money in a variety of investment vehicles and earn interest, as a return on those investments. The source of interest income can be any or all of these:
- Certificate of deposit.
- Corporate bond.
- Treasury bill.
- Treasury bond.
- Treasury note.
- Savings account.
- Interest-bearing checking account.
How Is Taxable Interest Taxed?
The IRS taxes the regular interest you earn from investments as ordinary income just as that earned on many other investment vehicles. Consequently, if your tax bracket is 22 percent, your tax liability on your interest income will be 22 percent. So, if a certificate of deposit paid $1,000 interest, the interest you owe on that interest income is $220.
Remember, however, that the total tax liability on income, including interest income, depends on a variety of things, including your filing status, tax bracket, total income, tax debits and credits, and dependents. So, when any of those factors change, your tax liability is likely to change.
Marginal Tax Rate
When one of the factors that affects your tax liability changes, some interest income may be taxed at a marginal rate. The marginal tax rate is that rate applied to every dollar a taxpayer earns in interest after a pre-established amount. For example, a 7 percent marginal tax rate means that, once a taxpayer's income is a certain amount, they will incur an additional tax liability of 7 cents for every subsequent dollar earned.
Understanding Form 1099-INT
Any financial institution that paid interest in an amount greater than $10 during the tax year must send you and the IRS a Form 1099-INT by January 31 of the following year. The Form includes a breakdown of the type and amount of interest income the institution paid and documents related expenses:
- Box 1 (Interest Income): Amount of regular interest paid from fully taxable instruments such as corporate bonds, mutual funds, CDs and bank deposits.
- Box 2 (Early Withdrawal Penalty): Total amount of early withdrawal penalties on CDs or other securities paid during the year.
- Box 3 (Interest on U.S. Savings Bonds and Treasury Obligations): Income on savings bonds and treasury obligations is separate from the income in Box 1 due to their unique tax treatment.
- Box 4 (Federal Income Tax Withheld): Total amount of "backup withholding" retained by the financial institution on your interest income if you did not furnish your TIN to the institution.
- Box 5 (Investment Expenses): Total amount of deductible expenses relating to investment income from a single-class real estate mortgage investment of conduits.
- Box 6 (Foreign Tax Paid): Tax on interest income that was paid to a foreign country.
- Box 7 (Foreign Country or U.S. Possession): The entity to which the tax in Box 6 was paid.
- Box 8 (Tax-Exempt Interest): Interest that's exempt from tax for any reason, including tax-free dividends from mutual funds.
- Box 9 (Specified Private Activity Bond Interest): This box reflects the tax-exempt interest that is subject to the alternative minimum tax.
When Is Schedule B (Form 1040) Used?
Assuming that interest income was a part of your investing strategy and you earned more than $1,500 of taxable interest, you'll use Schedule B (Form 1040) to report that income. The IRS requires that you complete Schedule B if any of the following items relate to your investments:
- You earned more than $1,500 of taxable interest or ordinary dividends.
- You received interest from a seller-financed mortgage, and the buyer used the property as a personal residence.
- You earned accrued interest from a bond.
- You are reporting original issue discount (OID) in an amount less than the amount shown on Form 1099-OID.
- You are reducing your interest income on a bond by the amount of amortizable bond premium.
- You are claiming the exclusion of interest from series EE or I U.S. savings bonds issued after 1989.
- You received interest or ordinary dividends as a nominee.
- You had a financial interest in, or signature authority over, a financial account in a foreign country or you received a distribution from, or were a grantor of, or transferor to, a foreign trust.
After you complete Schedule B, double-check the form to make sure the figures on the form match the figures on Form 1099-INT and submit it to the IRS with Form 1040.
As you complete the form, it's a good time to reconsider how interest income affects the overall growth of your portfolio. There may be other more tax-savvy ways to structure your investment portfolio. And remember, there are many more rules pertaining to interest income that are beyond the scope of this article. Consult a professional if you have any questions about taxation procedures and rules.