Although the treatment of taxable interest is relatively straightforward, there are a few twists.
Interest earned by a savings account is taxable in the year it is credited to your account, whether or not you withdraw the money. Even if a savings and loan or credit union labels the income on your account as dividends, the IRS says it's interest, and that's how you should report it.
With certificates of deposit that mature in a year or less, the interest income is taxable in the year the deposit matures. This rule permits you to shift taxable income from one year to the next and hold off Uncle Sam from one April 15 to the next. If you invested in a six-month CD in July 2006, for example, the interest will not be taxable until 2007, when the certificate matures. You would report the interest on your 2007 return filed in the spring of 2008.
Interest paid on time deposits with maturities of more than a year is taxable as it is credited each year. The institution where you invest should send you a Form 1099-INT showing how much you should report each year on your tax return.
If you withdraw funds early from a CD, the bank or S&L is likely to exact an early-withdrawal penalty. You can deduct that charge even if you do not itemize your deductions.
What about "gifts," such as the ubiquitous toasters offered by savings institutions to induce you to make a deposit? The value of the gift is included in the amount the bank tells the IRS it paid you during the year. The extra tax would be insignificant if a toaster is involved. But if you receive a pricey inducement—cars have been offered on multiyear, jumbo deposits—you could face a hefty tax bill.
If you set up custodial accounts for your minor children, the interest earned should be reported on the child's tax return, unless you qualify and choose to report the income on your own return (which we generally advise against). If the child's total income is less than $800, no return is required. In 2006, if the child's total income is less than $850, no return is required.
When married couples who file joint returns own joint accounts, there's no tax problem. All the interest is simply reported on the joint return. When unmarried taxpayers share an account, though, things can be complicated.
If you have a joint account with your sister, for example, the S&L will report income to the IRS in the name of the owner whose Social Security number is listed first on the account. That means you could be paying tax on interest that really went to your sibling. You can avoid that, but it will take some effort.
Here's how to do it. Assume you receive a Form 1099-INT from the S&L showing $1,500 of interest but that you and your sister have agreed to share the income in proportion to the amount invested in the account. You each have deposited half the funds, so $750 of the interest is yours, $750 hers. Because it was all reported to you, you're considered the "nominee recipient" of your sister's $750.
To shift the tax bill where it belongs, you need a blank 1099-INT form, which you can get at a local IRS office or by calling 1-800-TAX-FORM. Fill it out, showing $750 of interest income for your sister. Give your sister a copy of the form—by January 31 after the year for which the income was reported—and file another copy, along with a Form 1096 (also available from the IRS), with the IRS service center for your area by February 28. With those forms, you show yourself to be the payer of the interest and your sister to be the recipient. On your own return, you report the full $1,500 of interest as income on Schedule B, but also subtract the $750, labeling it as a "nominee distribution." The interview for interest handles this issue.
But what if you have signed on as a joint owner of a savings account belonging to a parent, for example, simply as a convenience so you can withdraw funds for them if necessary? The key is to be sure that the real owner of the account—your mother or father in this example—is the one whose Social Security number is listed first. The interest will be reported in her or his name, not yours. If things get fouled up and the income is reported in your name, you'll have to go through the nominee-distribution rigmarole.
Sometimes, particularly when mortgage rates are high, the sale of a home goes through only because the seller helps finance the deal. The selling price of your home—for purposes of determining whether you have a taxable gain—includes the face value of any mortgage or note you receive, as well as cash.
Assuming the gain is tax-free, payments on the note include the tax-free portion and the interest, which is taxable income to you. Your interest income goes on Schedule B. If the buyer is using the house as his or her home, you need to list his or her name and Social Security number. The interview will lead you through this issue.
On the face of it, the taxation of interest earned on corporate bonds is simple. These company-issued IOUs generally pay interest every six months, and it is taxable in the year you receive it. Fair enough. And it can work that way if you buy a bond at par—that is, at its face value—and hold it until maturity. Interest will be taxed as it is received, and when you redeem the bond for exactly what you paid for it, there will be no taxable gain, no taxable loss.
But things often don't work out so neatly.
For one thing, you can buy bonds at a premium (more than face value) or a discount (less than face value). Neither is necessarily a bargain, but both complicate your tax picture.
Interest is taxed as it accrues. Each year you own zeros, you must report and pay tax on the interest your investment is assumed to have earned that year. It's not as simple as dividing the discount by the number of years until maturity and reporting the result as your annual interest.
The method required by the IRS is much more complicated but, believe it or not, more advantageous to the taxpayer. Basically, interest is taxed as it would actually accrue. The rate of accrual accelerates over the life of the bonds, so each year you'll have more to report.
Fortunately, you don't need a computer to figure out how much to report. Each year you should receive from the bond issuer or your broker a 1099-OID showing how much interest you must report on your return. As usual, recordkeeping is essential. All zero-coupon-bond interest you report increases your basis in the bond, which will affect the gain or loss if you sell it before maturity.
The taxability of zeros makes them particularly attractive for funding retirement accounts, such as IRAs and Keoghs, in which the tax bill is deferred so you don't have to report the accruing interest each year.
Investors can buy tax-free zeros issued by municipalities, an investment that dodges the annual federal tax liability. Because the interest would be tax-free if it were paid periodically, there's no tax problem in having the accruing income assigned to you annually. Even though you face no annual tax bill, the accruing interest does hike your basis in the zero-coupon municipal. You must keep track to hold down the tax bill when you dispose of the bond. (Beware that although the IRS doesn't tax accruing interest on municipal zeros, your state might.)
The tax treatment of U.S. government obligations, such as U.S. Saving Bonds, is similar to that of corporate bonds. An important exception, though, is that interest on Treasury bills, notes and bonds is exempt from state and local income taxes—just as is interest on U.S. savings bonds.
If you sell a T-bill before maturity, part of the sales price is considered accrued interest and must be reported as interest income rather than taken into account when figuring capital gain or loss. The amount counted as interest is determined by dividing the number of days you owned the T-bill by the number of days in its term and multiplying the result by the discount.
Ordinary dividends are your share of the earnings and profits of the company whose stock you own. And, like interest on a savings account, such dividends are fully taxable. But not all dividends are considered ordinary and, therefore, different tax rules apply. As an investor, it's up to you to study the 1099-DIV form you receive reporting corporate distributions and make certain you pay tax on no more than you must. Our user-friendly Interview will make this a breeze, including making sure you get the benefit of the 15% rate for qualifying dividends. (Before 2003, such dividends were taxed in your top tax bracket.) We ask for the figures that appear in different boxes on your 1099-DIV forms and automatically plug those numbers into the tax forms where they belong to hold your tax bill to a minimum.
Even in years you don't sell shares, the IRS is interested in your fund investments, since they are likely to be generating taxable income. In January you should receive a 1099-DIV from each fund in which you own shares, showing income received during the year.
Income from money-market and taxable bond funds is considered dividend income for tax purposes, even though the source of the income is interest. The fact that it is being funneled through the fund changes its tax status. (If you goof and report this income as interest, you may hear from the IRS demanding tax on the dividends and a penalty for failing to report them. Straightening things out is a hassle you don't need.)
If you invest in a tax-free municipal-bond fund, the income passed through to you retains its shield from federal income tax. Although you don’t pay federal tax, the income may well be taxed by your state. However, the percentage of the income representing interest from bonds issued within your state may be state—tax-free, too. Your fund should tell you what portion of the income you received was attributed to such homegrown issues. If you can't find a report of such a breakdown in your files, call your fund's toll-free number and ask about it. It could save you money.
Many tax-exempt funds also hold "private-activity" bonds, and that interest could trigger or increase the alternative minimum tax. If you're subject to the alternative minimum tax, check the mutual fund's portfolio carefully. You may do better investing in a fund that spurns bonds potentially subject to the alternative minimum tax.
Some funds invest only in U.S. government securities, the interest from which would be free from state tax if the investor owned the obligations directly. Although most states allow income from such funds to retain that state-tax-free status, some states take the position that citizens who choose this type of fund are investing in the fund rather than in the U.S. obligations. With that rationale, those states tax the income. If you invest in this kind of fund, be sure to check on this point before you report the income on your state return.
Ordinary dividends—basically your share of the fund's dividend or interest income—are taxable in the year paid, whether you have the dividends paid out in cash or have them reinvested in new shares. Knowing when a stock fund declares dividends—the ex-dividend date—can give you a tax advantage. Generally, when the dividend is declared, the share value drops by about the same amount.
If you invest in the fund just before the ex-dividend date, the dividend you receive amounts to a refund of part of your purchase price. The problem is that you also get stuck with a tax bill on that dividend income. You'd be better off buying after the ex-dividend date, when you could buy the shares at their reduced price. Your out-of-pocket cost is the same, but your tax bill is lower.
There's a twist on this rule, too. If you plan to redeem shares before the end of the year, doing so before the ex dividend date might save you money. Why? Because selling before then means any ordinary dividends or short-term gains earned by the fund but not yet paid out show up as an increased share price and therefore boost your profit when you sell. As long as you've owned the shares for more than 12 months, you get the gentle 15% long-term capital gains rate (or 5% if you're in the 10% or 15% bracket). If you wait until the dividends are paid out, the portion that represents short-term gains, interest or "non-qualifying" dividends will be taxed in your top tax bracket. You would not want to make a selling decision on this point alone, but if you plan to sell around year-end anyway, a call to the fund about the ex-dividend date could pay off.
When it comes to long-term gains realized inside the fund and paid out to you as a capital gains distribution, you get the special long-term tax treatment even if you haven't owned the fund shares for more than 12 months.
Even a tax-exempt municipal-bond fund can show a taxable capital-gains distribution. That's not back-door taxation because the payout doesn't come from tax-free interest earned by the fund. Rather, it is your share of the profit realized when the fund manager sold bonds from the portfolio.
If you own a fund that invests heavily in foreign securities, you may be in line for a foreign tax credit. If so, your 1099-DIV will show the amount of foreign tax paid on your behalf. That amount is also included in the amount of taxable income you have to report. To even things out, you get the choice of either deducting it along with the other taxes you write off as itemized deductions or claiming the foreign tax credit. The credit is almost always your best bet.