Interest Income: Another Way for the IRS to Take Your Money
Jan 15 '02 (Updated Apr 12 '09)
The Bottom Line Interest income represents the money earned from investment in interest- bearing securities. It is taxed at your marginal rate, except for municipal bonds.
Many types of investments earn periodic payments of money, usually at a fixed percentage (but sometimes, they can be variable) that is agreed upon when the investment is purchased. This type of return on investment is known as interest income, and the money received must be reported as taxable income.
What Investments Pay Interest Income?
Several types of investments pay periodic interest. The most popular of these is a simple savings account with a financial institution. Savings accounts often carry a variable interest rate that gets adjusted at fixed intervals, to reflect the prevailing rates at the time. Right now, bank savings accounts are paying very little interest because rates have been declining for quite some time.
Other types of investments carry a fixed interest rate. This would include bank certificates of deposit, corporate bonds, treasury bills and bonds, etc. In the case of corporate bonds and treasury securities, the market value of the bond changes (as interest rates rise and fall), but the interest rate is fixed, for the life of the bond.
Dividends on stock are taxable (even if you reinvest them, you still have to pay tax in the year you receive them), and they have similar characteristics as interest, with a few exceptions. For one thing, dividends per share rates can change quickly, if a company's board of directors decides to make a change. Also, dividend yields (similar to an interest rate) vary widely and change quickly, from day to day, based on the price of the underlying stock. For example, if I purchase shares of stock that are currently priced at $20 per share, with an annual dividend of $1, then the dividend yield would currently equal 5 percent. But, if the price of the stock increases to $30 and I purchase some more shares, my $1 annual dividend will now yield only 3.33 percent.
How Much Tax Will I Pay?:
Because interest income is taxed as ordinary income, you will have to pay tax equal to your current marginal rate. Your marginal rate is the top tax bracket that you currently reside, which could be as low as zero percent, and as high as 39.1 percent.
Dividends are taxed the same way. You will have to pay tax equal to your current marginal rate. However, there is one feature of dividend income that few are aware. While it's true that individuals must pay tax at the marginal rate on 100% of the dividends received, this doesn't apply to corporations that receive dividends. If a corporation has invested in the stock of other companies and receives dividends, 70 percent of the income received is exempt from Federal tax. I'm not sure exactly why the IRS has a tax loophole like this, for corporations. Logically, this exemption would seem to encourage corporations to own stock in high- dividend paying corporations, like utilities. How this benefits anyone, I'm not sure. There's nothing wrong with encouraging corporations to buy the stock of other companies, but I don't see how this is any more beneficial than having individual investors buy these high- yielding stocks.
How Do I Report Interest Income?:
To report your taxable interest earnings, you need to fill in the box on 1040 form, line 8a; 1040a form, line 8a; or 1040EZ form, line 2. If special circumstances apply (like earning more than $400 interest; receiving accrued interest; receiving tax- exempt interest; etc.) then you will also need to fill out schedule B.
Dividend income is reported on line 9 of both the 1040 and 1040a forms. You cannot use form 1040EZ, if you have dividend income.
Is There any Interest Income That Isn't Subject to Tax?:
Most all interest income is federally taxable, but there is one exception: municipal bond interest. Municipal bonds include bonds that are issued by states and local government authorities. The interest earned on these investments is tax- exempt, on the Federal level. This makes municipal bonds attractive to those individuals who currently pay a high marginal tax rate. The stated interest rate on municipal bonds is usually a few points lower than a corporate bond of equal quality, because of the tax- exempt advantage. Depending on your current tax rate, municipal bonds can sometimes prove to be more lucrative than corporate bonds.
For example, let's say you are considering buying either a corporate bond with an interest rate of 10 percent, or a municipal bond with an interest rate of 7 percent. If your marginal tax rate is, say, 15 percent, then the corporate bond would produce an after- tax yield of only 8.5 percent, but it would still be better than the 7 percent rate offered by the municipal bond. However, if your marginal tax rate is high, like 31 percent, then the after- tax return on the corporate bond would drop to 6.9 percent, making the municipal bond the best one to purchase.
Final Thoughts:
Interest income is a nice (albeit, small) supplement to your annual pay. You receive interest in exchange for the use of your funds, and this additional income is then taxed, at your marginal tax rate.
I teach finance at a local university, and we have been discussing the tax implications of interest and dividend income for the past week. Most were aware of the fact that these types of income are taxed at the marginal rate, but the students were enlightened when they heard about tax- free municipal bond interest and the 70 percent exclusion of dividends from corporate taxable income. This is the first time they had ever heard these facts.
For those in high marginal tax brackets, municipal bonds can often result in higher interest income than corporate bonds. It's a good idea to shop around, to make sure that you don't cheat yourself out of some additional income.
Interest income provides steady cash flow, and interest- bearing investments are usually far less risky than non- interest bearing investments, like common stock. For these reasons, interest income is favored by both retired people and risk- averse individuals who don't want to take chances with their investments.
Interest income can help add cash flow to your monthly revenue, but you need to remember that the money is fully taxable (except for municipal bond interest), at your current marginal rate. Remember to report your interest income, in the proper box on your tax form.
Until the tax code changes, taxpayers will be charged tax on most all forms of interest income, so grit your teeth, and bear it!
For more information on federal income taxes, be sure to read the following essays:
Federal Tax Withholding
Federal Exemptions
Short Term Capital Gains and Losses
Long Term Capital Gains and Losses
Capital Losses and Tax Treatment
Standard Deduction
Charitable Contributions
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