Interest Income: I Didn’t Know That!

With interest rates so low for so long, many taxpayers have abandoned interest-bearing investments in hopes of greater returns. Still many other taxpayers continue to favor certain types of interest-bearing investments because of their security of principal.

Normally, most types of interest are taxable, and in most cases this interest becomes taxable when it is actually or constructively received. But interest rules can be confusing; interest isn’t always taxable, and even if taxable, the timing for reporting the interest may not be what you think. Here are some points of clarification.

When Interest on CDs Is Taxable

Interest on certificates of deposit (CDs) or time-savings accounts generally is taxable as it accrues. For CDs with a term of 1 year or less, interest is taxable in the year it is available for withdrawal without a substantial penalty. The tax law does not define “substantial penalty.”

In one recent case, a retiree supplemented his Social Security benefits by investing in CDs with maturies of 9 to 12 months’ duration. He reported only the interest received when the CDs matured (or when he cashed them in early) on the grounds that the interest was not taxable in the year in which it accrued because there was a risk of substantial penalty (i.e., a 3-month forfeit of interest). The Tax Court rejected the retiree’s argument in this case.

While the regulations admit that a 3-month forfeiture could be considered a substantial risk that would bar the taxation of interest until actual receipt, in this case the retiree failed to demonstrate his actual penalty risks (he made vague references to the 3-month forfeiture). He did not produce his CD contract or other information from the banks explaining the penalty risks for his CDs. Thus, he was taxed as the interest accrued; this amount was reported to him on Form 1099-INT.

When Interest on Municipal Bonds Is Taxable

Interest on bonds issued by state or local governments generally is exempt from federal income taxes. The interest, however, is taken into account in figuring the portion, if any, of Social Security benefits subject to tax. And in some situations, the interest may be subject to the alternative minimum tax.

Interest on Build America bonds (BABs), which are a type of municipal bond created by the American Recovery and Reinvestment Act of 2009 and that receive federal assistance, generally is taxable. The issuer gets the federal help, which enables the municipality to offer higher interest rates to investors. (Note: Under the tax law, BABs can, in the alternative, be issued to enable investors to claim a credit rather than having the issuers use it, but this is not being done in the investment community.) The BAB program is set to lapse at the end of 2010, but Congress is now considering an extension.

Interest on municipal bonds may be exempt or subject to state and local income taxes. Check with your state on its tax rules.

When Interest on Savings Bonds Is Taxable

Interest on U.S. savings bonds, series EE and I, are taxable. Tax generally is deferred until the bonds are redeemed or mature. Bondholders can instead report the interest currently.

Interest on U.S. savings bonds can be fully or partially tax free when the bonds are redeemed to pay higher education costs and certain conditions are met. Specifically, you must be over 24 years old when you buy the bonds and redeem them to pay qualified higher education costs for yourself, your spouse, or your dependent. While there is no cap on the amount of interest you can exclude, you qualify for the exclusion only if your income is below a modified adjusted gross income (MAGI) threshold that’s adjusted annually. The threshold for 2010 is $70,100 for singles and $105,100 for joint filers. The exclusion phases out and eventually disappears when MAGI exceeds $85,100 for singles and $135,100 for joint filers.

Interest on U.S. savings bonds, whether taxable or tax free for federal income tax purposes, is always tax free for state and local income tax purposes.

Series I bonds can be purchased directly from the Treasury using tax refunds. Bonds must be purchased in increments of $50; the limit for the refund purchase is $5,000. To make this type of purchase, indicate this on Form 8888; for the routing number on this form, enter “043736881,” and for the account number, enter the word “BONDS.” The government will set up a Treasury Direct account for you; the account holds your bonds (you do not receive any bond certificates).

When Interest on TIPS Is Taxable

Treasury Inflation-Protected Securities, or TIPS, are a type of bond issued by the federal government to provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you receive the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, and the rate, which is fixed, is applied to the adjusted principal. Interest payments as well as the growth in principal are taxable for federal income tax purposes, even though no interest and/or principal is paid until the TIPS mature.

Interest (and the principal adjustment treated as interest) is exempt from state and local taxes just like interest on other U.S. Treasury notes and bonds.

Note: Because you are taxed on interest, even though the payments are not received, it may make sense to hold this type of interest-producing investment in a tax-deferred account, such as an IRA.