There is probably no one who likes taxes. Most of us pay our fair share, whether income taxes, property taxes, sales taxes or other taxes. Taxes are levied by the federal government, the states and municipalities. Investment income is subject to federal taxes. Many states also tax investment income, although laws vary. Interest income is one component of investment income.
Investment Accounts and Tax Status
Not all investment income is subject to taxes. Interest and dividend income received in qualified retirement plan accounts and traditional IRA accounts are exempt from taxes. Investments in these plans grow untaxed. Taxes are paid when you withdraw funds. Roth IRAs are also tax-exempt accounts. Funds grow untaxed and, if taken out according to IRS guidelines, are not taxed. Interest income received in nonqualified investment accounts, including individual and joint brokerage accounts, may be subject to taxes.
Sources of Interest Income
Interest income comes from many different sources. Not all interest income is taxable. Some income is federal tax-exempt, some exempt from state taxes, and some interest may be subject to taxes by one government entity, such as a state, and not by the federal government. Bonds are one source of interest income. These include certificates of deposit, Treasury securities, government agency bonds, corporate bonds and municipal bonds. Many financial institutions pay interest on checking accounts and savings accounts. Mutual fund distributions may include interest payments.
Interest income received during a calendar year subject to taxes is taxable income. Interest received on certificates of deposit, bank accounts and corporate bonds is subject to federal taxes. Interest from U.S. Treasury securities is subject to Federal taxes. Most government agency bond interest is taxable. Quite a few states tax dividend and interest income. Taxpayers receive a Form 1099-INT from the payer in the year following the interest distribution if the interest paid was more than $10 . The interest must be reported on the federal tax form, whether or not taxes are due. Some dividends received are categorized as interest, including dividends from credit unions, savings and loans, and mutual savings banks. The institution records the interest on a Form 1099-INT that it mails to the account owner.
Nontaxable Interest Income
Most municipal bonds are tax-exempt at the federal and state level. The state tax exemption usually applies to municipal bonds issued by the investor's home state and municipalities. Other municipal bonds, such as Puerto Rico bonds, may be tax-exempt as well. Municipal bonds from states other than the investor's state of residence are usually subject to state tax. The municipal bond interest must be reported on the tax form whether or not taxes are payable. Series EE and I savings bonds are tax-exempt if the money is used for educational expenses. The exemption phases out at specific income levels.