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 and delay paying tax 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 1099-INT form you receive from your bank will show the interest income to be reported on your 2006 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.
A huge changes in the taxation of dividend income arrived in 2003. In the past, ordinary dividends — which are your share of the earnings and profits of the company whose stock you own — were taxed just like interest income or your salary. That is, taxed in your top tax brackets. But as part of the 2003 tax cut, Congress decided to apply the 15% long-term capital gains rate to dividends. For taxpayers in the 10% or 15% bracket, in fact, the tax on their dividend income is now just 5%.
Of course, there are complications: different kinds of dividends are treated differently—for example, dividends paid by money market mutual funds and credit unions (which really represent interest) will continue to be taxed in your top tax bracket. Fortunately, it should be easy for you to take full advantage of the new rules. Form 1099-DIV — on which payers report dividends to investors — has been redesigned to segregate dividends that qualify for the new 5%/15% rate from those that do not. And our user-friendly Interview has been redesigned, too. 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.
Dividends are taxable in the year they are paid to you, even if you reinvest the money in additional shares. If you are in a dividend-reinvestment plan, for example, your taxable income for the year includes dividends that are reinvested in additional shares even though you never put your hands on the cash. When a plan permits you to buy shares at a discount from current market value, the amount of the discount is included in your taxable dividend income for the year.
Assume that you use your dividends to buy 50 shares of stock at a $2.50-per-share discount. That would give you an extra $125 of dividend income. Your basis in the new shares would be their true market value, that is, what you paid plus the discount amount you had to include in your income. Many reinvestment plans let shareholders buy extra shares, with cash, at a discount, too. If you take advantage of such an offer, the amount of the discount on the extra shares is considered dividend income.
What if the corporation decides to pay dividends on its common stock with extra shares of common stock rather than in cash? Generally, such stock dividends are not taxable. Rather, the new shares simply dilute your basis in the stock, meaning you'll wind up paying tax on the dividend when you ultimately sell the stock.
Say you have 100 shares of stock with a basis of $5,000 and you get a stock dividend of ten shares. The $50-a-share basis in the stock ($5,000 divided by 100) becomes a $45.45-a-share basis ($5,000 divided by 110).
If shareholders are given the option of taking the dividend in stock or in cash, the dividend is taxable even if you take the shares. You are taxed on the market value of the stock you receive. In this case, however, the basis of your original shares does not change and your basis in the new shares is the amount you have to include in income.
Companies sometimes make cash payments to shareholders that don't come out of earnings and profits but rather represent a return of part of the investors' original investment. Such returns of capital distributions are not taxable. Instead, they reduce your basis in the stock. That will hike your profit or reduce your loss when you eventually sell the shares but has no immediate effect on your tax bill.
Although taxpayers are often confused, dividends paid on life insurance policies are not dividends as far as the IRS is concerned. Rather, the payments are simply considered a refund of part of the premium you paid for the policy. Such dividends are not taxable, whether you receive them in cash or have them applied to reduce the premium the following year. (As usual, there's an exception: In the unlikely event the dividends surpass the total of premiums paid, the excess would be taxed.)