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Almost everyone has heard of interest and knows what it is, essentially, making money on your money. It’s a fact of our financialized world, and one that has become the source of much fantasy. Almost everyone has thought to themselves, “Wouldn’t it be amazing to live off nothing but interest.” And almost everyone is right; it would be amazing. But alas, it’s just not realistic for the vast majority of people because earned income from a job reigns supreme in this universe. Anyway, this post goes into the more interesting and less well known aspects of interest. It’s a veritable salad bowl of information.

Technically, interest is the fee you are paid to loan your money to someone. In this way, you’re paid to let someone else use your money. Hence, a bank account that is interest bearing pays you money so the bank can loan your money out to borrowers (at a much higher interest rate, but I digress).

Interest is reported to the taxpayer in the year following a given a tax year on Form 1099-INT. In this vein, interest income is almost never subject to regular withholding, so your bank or other financial institution won’t withhold an amount for taxes and remit it to the IRS on your behalf. Additionally, if you notice that an amount on your Form 1099-INT is incorrect, you should ask the issuer to correct the form, in which case you should receive a new Form 1099-INT with the box at the top labeled “CORRECTED” checked. Furthermore, to dispel a commonly held myth about income, any amount of interest income not reported to you on a Form 1099-INT is still 100% taxable and should be reported on your return. One of the exceptions to this general rule comes in the form of exempt interest dividends. These are generally paid by a mutual fund or investment company, and show up on your Form 1099-DIV in box 11.

A common type of interest bearing instrument is U.S. savings bonds. The interest from these bonds is taxable, like most other interest earned, and should be reported using one of two methods. If you use the accrual method, which is outside the scope of this article, then you report the interest in the year that it accrued but was not necessarily received. If you use the cash method of accounting, which is the method most individuals use, then the interest is reported in the year that you received it, in other words, in the year it showed up in your bank account. However, there is an exception here. When you participate in the Education Savings Bond Program the interest on the bond may be excludable from your taxable income. However, this program has specific requirements that have to be followed in order to qualify for the exception, and therefore it should not be taken for granted that the interest earned will be tax free.

Similar in kind to savings bonds are U.S. treasury bills, notes, and bonds. These are the American government’s direct debts, meaning that they are owed by the government to the holder. While you must pay federal income tax on the interest earned from these debt instruments, they are exempt from all local and state taxes, so they offer some tax advantage.

Bonds generally pay interest at specified times during the year, such as every six months. Therefore, if you sell or purchase a bond in between these periods, partial interest has accrued which factors into the sales price. The solution to this is simple. For the seller, you must account for this partial interest and pay taxes on it, even though you received it in the sales price. For the buyer, the first interest payment you receive after purchase is partially nontaxable in the amount that you paid as the built-in interest in the purchase price of the bond.

Finally, there’s a term related to interest that you may have noticed regarding investment instruments, but its definition, at least to me, was always illusive. That term is original issue discount. Original issue discount is a form of interest accrued through a debt instrument that is sold for less than its stated future value at maturity. The tax on original issue discount interest is paid as the value accrues, regardless of whether the payment for that value is actually received. In other words, the taxes are paid on original issue discount before redemption.

Interest income is reported on your tax return in part 1 of Schedule B. Looking at Schedule B, you’ll notice that line 3 asks for the excludable interest on series EE and I U.S. savings bonds, and further, to attached Form 8815, Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued after 1989. This line is where you exclude your interest income from the U.S. savings bonds that are used to participate in the Education Savings Bond Program.

For more information on the different types of taxpayer income, see IRS Publication 17.

If you have any problems with figuring or reporting interest, don’t hesitate to call Dino Tax Co today at (713) 397-4678 or email us at davie@dinotaxco.com. The first phone consultation is always free, so ask any questions you may have. Also, consider liking us on Facebook: www.facebook.com/dinotaxco.