Content of the material
- What Is Interest Income?
- Key Takeaways
- About Schedule B
- Who owes the tax?
- Examples of Nontaxable or Excludable Interest
- The financial takeaway
- Where is taxable interest income reported on the tax return?
- PA Taxation of Specific Investments as Interest Income
- Burial Fund Earnings
- Insurance Companies
- IRA, Keogh Accounts, or Pension Trusts
- Amounts Paid Under Contract of Life Insurance, Endowment or Annuity
- Charitable Gift Annuities
- Imputed Interest and Original Issue Discount (OID)
- Interest from Refunds of Tax Overpayments
- Tax-Exempt Interest
- Obligations of Federal Agencies, Instrumentalities and Territories Exempt from Pennsylvania Personal Income Tax
- Obligations of Federal Agencies, Instrumentalities and Territories Not Exempt from Pennsylvania Personal Income Tax
- STRIPS, CATS, ETRS, LIONS, FICOS and Other Stripped-Exempt Bonds
- Gain (Loss) from the Sale, Exchange or Disposition of Tax-Exempt Obligations
- Obligations of Other States
- Repurchase Agreements
- Distributions from Money Market Funds, Mutual Funds and Other Investment Companies
- Nominee Interest
- Trust Other than a Business Trust
- Distributions from IRC § 529 Qualified Tuition Programs for Non-Educational Purposes
- Distributions from IRC § 529A Achieving a Better Life Experience Savings Program Accounts
- Distributions from Health or Medical Savings Accounts
- Interest Income from PA S Corporations and Partnerships
- The Bottom Line
What Is Interest Income?
Income is any money that someone earns in exchange for providing a good or service. Income can also be received by making investments with capital. As such, it can be generated from many different sources, such as from an employer, through tips from customers, and by earning capital gains, dividends, and interest from investments.
Most governments require individuals to report and pay taxes on any income they receive each year. This means that taxes must be paid by investors who receive interest income from their bonds, mutual funds, certificate of deposits (CDs), and demand deposit accounts.
Some types of interest are fully taxable, while other forms are partially taxable. But how do you know which one is which? This article will break down the different types of interest and how each kind is taxed, as well as which forms you need to correctly report them.
Key Takeaways Interest on bonds, mutual funds, CDs, and demand deposits of $10 or more is taxable.Taxable interest is taxed just like ordinary income.Payors must file Form 1099-INT and send a copy to the recipient by January 31 each year.Make sure you understand your Form 1099-INT in order to report the figures properly.Interest income must be documented on B on Form 1040 of the tax return.
About Schedule B
Schedule B is a supplemental tax form used to tally up interest and dividend income, particularly if you receive it from multiple sources. You can also use the schedule to total your interest and dividend incomes so you can report them on your Form 1040, even if you're not required to file it.
Using and filing Schedule B is mandatory if you have over $1,500 in interest or dividends.
Who owes the tax?
|Situation||Who owes the tax|
You are the only owner of the bond
You use your money to buy a bond that you put in your name with a co-owner
You buy the bond but someone else is named as the only owner
The person who is named as the owner (not you)
You and another person buy a bond together, each putting in part of the money to buy the bond, and you are both named as co-owners
You and the other person must each report the interest in proportion to how much you each paid for the bond
You and your spouse live in a community property state and buy a bond that is community property and you file separate federal income tax returns
You and your spouse each report one-half of the interest
|Reissue: Change in Ownership Reissuing Paper I Bonds||Who owes the tax|
You give up ownership of the bond and the bond is reissued
You owe tax on the interest the bond earned until it was reissued
You are the new owner of a bond that was reissued
You owe tax on the interest the bond earns after it was reissued but when or after you cash the bond, the 1099-INT (see below) will show all interest earned from date of issue, including interest earned before it was reissued. See instructions in IRS Publication 550 for paying tax only on interest earned after the bond was reissued.
Examples of Nontaxable or Excludable Interest
- Interest redeemed from Series EE and Series I bonds issued after 1989 may be excluded from income when used to pay for qualified higher educational expenses during the year and you meet the other requirements for the Educational Savings Bond Program. Figure the amount of excludable interest on Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989 and show it on Schedule B (Form 1040), Interest and Ordinary Dividends. Refer to Publication 550, Investment Income and Expenses for detailed information.
- Interest on some bonds used to finance government operations and issued by a state, the District of Columbia, or a U.S. possession is reportable but not taxable at the federal level. Reporting tax-exempt interest received during the tax year is an information-reporting requirement only and doesn’t convert tax-exempt interest into taxable interest.
- Interest on insurance dividends left on deposit with the U.S. Department of Veterans Affairs is nontaxable interest and not reportable.
The financial takeaway
No matter the source, most interest earned by your savings and investments counts as taxable income. It’s taxed at the same rate as ordinary income — based on your regular tax bracket for the year.
Avoiding interest income tax boils down to seeking out certain exempt assets — mainly municipal bonds and US Treasuries — and using tax-advantaged accounts, in which money earns tax-free or at least tax-deferred.
The financial institutions holding your accounts send annual statements of your interest income called Form 1099. So keep track of these, and report all of your investment income. The IRS gets copies of all of your 1099s, so they’ll know quickly if you leave anything out.
Where is taxable interest income reported on the tax return?
If you received more than $1,500 of taxable interest or dividends during the year, you report all of that interest and dividend income on Schedule B attached to your Form 1040 . If your earnings didn’t reach that threshold, you don’t need to fill out Schedule B. Instead, you just report tax-exempt interest and taxable interest on lines 2a and 2b of your Form 1040.
Your 1099-INT forms should have all the info you need. They may not be complete, though. Banks and brokerage firms are only required to send you a form if they paid you more than $10 in interest during the year. So if you earned $5 in interest from a savings account, it’s still taxable – you just might not get a 1099-INT.
So, it’s a good idea to keep track of it yourself, too — because you’re required to report all interest income on your return, no matter how small. If you have lots of accounts in various places, it could add up.
PA Taxation of Specific Investments as Interest Income
Burial Fund Earnings
Refer to PA Personal Income Tax Guide - Estates, Trusts and Decedents for information regarding the taxation of pre-need funeral trusts or cemetery merchandised trusts regarding burial fund earnings.
Interest income on dividends from insurance companies, whether disbursed or not, is taxable as interest income.
IRA, Keogh Accounts, or Pension Trusts
Undistributed unearned income accruing in IRA, Keogh Accounts or Pension Trusts is not taxable as interest income.
Amounts Paid Under Contract of Life Insurance, Endowment or Annuity
For taxable years beginning after Dec. 31, 2004, income from annuity contracts purchased as retirement annuities that are not from an employer-sponsored retirement annuity or are not part of an employer-sponsored program, are now taxable as interest income. Any income from these types of plans that is taxable for federal income tax purposes is now taxable for Pennsylvania personal income tax purposes as interest income as a result of Act 40 of July 7, 2005. Act 40 also provides that amounts paid under contract of life insurance or endowment, which may be included in gross income for federal income tax purposes, are also subject to Pennsylvania personal income tax as interest income. Previously, the income received from an annuity that you purchased, including a retirement annuity that is not part of an employer-sponsored retirement program was reported as gain on the sale, exchange or disposition of property. Refer to PA Personal Income Tax Guide – Net Gains (Losses) From the Sale, Exchange or Disposition of Property for the old rules for annuities.
Charitable Gift Annuities
For taxable years beginning after Dec. 31, 2004, income received from a charitable gift annuity contract is taxable as interest income. Any income from a charitable gift annuity that is taxable for federal income tax purposes is reported as interest income for Pennsylvania personal income tax purposes. Previously, income received from charitable gift annuity contracts was taxable in the same manner as gain on sale, exchange or disposition of property using the cost recovery method to determine the amount taxable for Pennsylvania personal income tax purposes.
Imputed Interest and Original Issue Discount (OID)
Imputed interest is taxable under Pennsylvania personal income tax law. Imputed interest is the implied interest on an obligation where the instrument does not provide for interest or the interest rate is below the applicable federal rate (AFR). For example, on an original issue discount bond (OID), a stripped bond, or a certificate of deposit (CD) maturing in several years where interest is received at maturity, the imputed or accrued interest (discount on original issue discount bond) is reported each year for Pennsylvania personal income tax purposes.
Pennsylvania and federal rules for imputed and accrued interest are the same. Under Pennsylvania law (Act 68 of 1993) for tax years beginning on or after Jan. 1, 1993, original issue discount is calculated in the same manner as it is calculated for federal income tax purposes. For the purpose of determining taxable gain or income from the sale, exchange or disposition of original issue discount bonds, a holder’s adjusted basis is increased by the amount of original issue discount bond accrued with respect to such bonds and is adjusted downward, but not below zero, by the amount of payments under the original issue discount bond, other than payments of stated interest.
The applicable Pennsylvania regulations require that unstated or imputed interest be calculated in the same manner as it is calculated for federal income tax purposes. The Pennsylvania Department of Revenue’s policy is to look at federal rules regarding the transactions that result in or that are exempt from unstated or imputed interest, how unstated or imputed interest is to be calculated and when it is realized. Consequently, any amount of unstated or imputed interest that is includable in gross income for federal income tax purposes is subject to Pennsylvania personal income tax as interest income.
Interest from Refunds of Tax Overpayments
Interest paid to taxpayers on tax overpayments by the Pennsylvania Department of Revenue, the Internal Revenue Service, foreign governments or by local taxing authorities, is no different than any other taxable interest payments. Such interest is derived from "open accounts," not obligations that are statutorily free from state taxation. Therefore, interest paid to taxpayers on tax overpayments by the Internal Revenue Service, Pennsylvania Department of Revenue or any applicable state is taxable interest income in Pennsylvania.
Interest is not taxable income if received from direct obligations of the Commonwealth of Pennsylvania, its political subdivisions and authorities or the U.S. government. Likewise, interest from Series E, F, G, H, EE and HH bonds and federal treasury bills and notes are not taxable. Although not taxable, interest income from these obligations is required to be included as adjustments to the amount of interest income taxable for federal income tax purposes. Interest income from direct obligations of the Commonwealth of Pennsylvania, its political subdivisions and authorities is an adjustment on Line 6 of PA-40 Schedule A, Interest Income. Interest income from the U.S. Government is an adjustment on Line 7 of PA-40 Schedule A.
Obligations of Federal Agencies, Instrumentalities and Territories Exempt from Pennsylvania Personal Income Tax
- Banks for Cooperatives, 12 USC §2134
- Federal District Banks for Cooperatives, 12 USC §2121
- Central Banks for Cooperatives, 12 USC §2121
- Commodity Credit Corporation, 15 USC §713a-5
- Farm Credit System Capital Corporation: Consolidated Obligations, 12 USC §2278a-11 (replaces 12 USC §2216k)
- Farm Credit System Joint Stock Banks, 12 USC §2023 (12 USC §931 replaced by 12 USC §2055, replaced by 12 USC §2023)
- Farm Credit System Land Banks and Land Bank Associations, 12 USC §2023
- Federal Crop Insurance Corporation, 7 USC §1511
- Federal Deposit Insurance Corporation, 12 USC §1825
- Federal Farm Credit Banks (merger of Federal District Intermediate Credit Banks and Federal Land Banks, 12 USC §2011), 12 USC §2023
- Federal Financing Bank, 12 USC §2290(b)
- Federal Home Loan Banks, 12 USC §1433
- Federal Land Bank Associations, 12 USC §2098
- Financing Corporation, 12 USC §1441(e)(7)
- General Insurance Fund, issued under Armed Services Mortgage Insurance, 12 USC §1748(b)(f) National Defense Housing Insurance, 12 USC §1750c(d) Rehabilitation and Neighborhood Conservation Housing Insurance, 12 USC §1715k(h)(7) Rental Housing Insurance Fund, 12 USC §1747(g) Rental Housing Insurance Fund Mortgage Insurance, 12 USC §1713(i) War Housing Insurance law, 12 USC §§1739(d) and 1744(e) Insurance of Loans for Manufacture of Houses, 12 USC §1744(i)(4) (refers to 12 USC §1739) Mortgage Insurance Benefits, 12 USC §1750c
- Government of the Northern Mariana Islands, 48 USC §1801, and Covenant to Establish a Commonwealth of the Northern Mariana Islands in a Political Union with the U.S. States Article IV 607(a)
- Government of Puerto Rico, 48 USC §745
- Government of Virgin Islands, 48 USC §§1403, 1574(b)(iii)(A)
- Government of Guam, 48 U.S.C. §1423a
- Public Building Trust Participation Certificates, 31 USC §3124(a)
- Mutual Mortgage Insurance Fund, 12 USC §1710(d)
- National Credit Union Administration Central Liquidity Facility, 12 USC §1795k(b)
- Production Credit Associations, 12 USC §2077
- Public Housing Agencies, 42 USC §§1437i, 1437c(g)
- Resolution Funding Corporation (REFCORP), 12 USC §1441b(f)(7), 12 USC §1432
- Student Loan Marketing Association, 20 USC §1087-2(l)
- Tennessee Valley Authority, 16 USC §831n-4(d)
- U.S. Postal Service, 39 USC §2005(d)(4)
- U.S. Treasury Bonds, Notes, Bills, Certificates, and Savings Bonds, 31 USC §§3124, 3102-3106, 3109
Obligations of Federal Agencies, Instrumentalities and Territories Not Exempt from Pennsylvania Personal Income Tax
Unless they are issued to the Secretary of the Treasury and all purchases and sales by the Secretary of the Treasury of such obligations is treated as public debt transactions of the U.S., the following obligations of federal agencies, instrumentalities or territories are not exempt from taxation on interest or gain under the Pennsylvania Personal Income Tax Act:
- Agricultural Credit Insurance Fund (Agricultural Credit), 7 USC §1929(c)
- Pacific Northwest Transmission (Bonneville Power Administration), 16 USC §838k(c)
- Electric and Hybrid Vehicle Development Fund, 15 USC §2509(e)(3)(c)
- Export-Import Banks, 12 USC §635b
- Federal Financing Bank, 12 USC §2288
- Federal Home Loan Mortgage Corporation, 12 USC §1455(a)
- Federal National Mortgage Association (Fannie Mae), 12 USC §§1719(e) (see 1723a(c))
- Federal Ship Financing Fund (Merchant Marine Act), 46 USC §53723
- Geothermal Resources Development Fund (Geothermal Research), 30 USC §1144
- Government National Mortgage Association (Ginnie Mae), 12 USC §§1721 and 1723 (see 1721(d), 1721(g), 1723a(c)) • U.S. Housing Authority, Low-rent Housing, 42 USC §1437b • Pension Benefit Guarantee Corporation, 29 USC §1305(c)
- Rural Development Insurance Fund, 7 USC §1929a(d)
- Rural Housing Insurance Fund, 42 USC §1487(h)
- Rural Telephone Bank, 7 USC §947(b)
- Securities Investor Protection Corporation (Securities Investor Production Fund), 15 USC §78ddd(h)
- Small Business Administration, 15 USC §633(c)(5)(A)
- U.S. States Railway Association, 45 USC §720(e)
STRIPS, CATS, ETRS, LIONS, FICOS and Other Stripped-Exempt Bonds
The federal-taxable income or gain derived from exempt bonds that are issued with interest coupons where there is a separation in ownership between the bond and any coupon that has not yet become payable is taxable as follows:
- The tax-exempt portion of the original issue discount with respect to the stripped coupon or stripped bond is the excess of the stated redemption price at maturity (or in the case of a coupon, the amount payable on the due date of the coupon), over an issue price that would produce a yield on the maturity as of the purchase date (of the stripped coupon or stripped bond) equal to the lower of the coupon rate of the tax-exempt obligation from which the coupons were separated or the yield to maturity on the basis of the purchase price of the stripped coupon or stripped bond.
- The remaining portion of the discount is treated as original issue discount with respect to an obligation that is not tax-exempt and as imputed interest.
A tax-exempt obligation with a face amount of $100 due Jan. 1, 1990 and with a coupon rate of 10 percent compounded semi-annually is issued for $100 on Jan. 1, 1987 and is stripped on Jan. 1, 1989. The right to receive the principal amount is sold for $79.21, reflecting a yield to maturity at the time of the strip of 12 percent compounded semi-annually. The tax-exempt portion of discount on the stripped bond is limited to $17.73, the difference between the stated redemption price of $100 and the issue price that would produce a yield to maturity of 10 percent ($82.27). This portion of the discount on the stripped bond in excess of the tax-exempt portion is $3.06, equal to the excess of total discount ($20.79) over the tax-exempt portion. This portion of the discount is treated as original issue discount bond with respect to an obligation that is not tax-exempt.
Gain (Loss) from the Sale, Exchange or Disposition of Tax-Exempt Obligations
Gain (loss) on the sale, exchange or disposition of tax-exempt obligations issued by the Commonwealth, a public authority, commission, board or other agency created by the Commonwealth, a political subdivision or obligations exempt from state taxation under the laws of the U.S. only with respect to obligations issued on or after Feb. 1, 1994, is taxable in Pennsylvania.
The tax-exempt portion of the original issue discount bond with respect to a stripped coupon or stripped bond is the excess of the stated redemption price at maturity (or in the case of a coupon, the amount payable on the due date of the coupon), over an issue price that would produce a yield to maturity as of the purchase date equal to the lower of (1) the coupon rate of the tax-exempt obligation from which the coupons were separated, or (2) the yield to maturity (on the basis of the purchase price) of the stripped coupon or stripped bond. The taxpayer can elect to use the original yield to maturity instead of the coupon rate for these purposes.
In addition, the premium paid on a bond is included in the basis of the investment for the bond. The amortization of the premium is a partial return of the investment in that premium and is a reduction to the basis for each interest payment received. See Bond Premium Amortization in this chapter for additional information.
Obligations of Other States
Interest on obligations of other states, territories and their political subdivisions, and instrumentalities is taxable for Pennsylvania personal income tax purposes.
Interest earned from repurchase agreements (“REPOS”) is not tax-exempt interest income; and interest received on obligations, which are only guaranteed by the federal government, is subject to tax.
Distributions from Money Market Funds, Mutual Funds and Other Investment Companies
Taxable distributions from the earnings and profits of money market or mutual funds, investment trusts and investment companies must be reported as dividend income not interest income. This rule applies even if the company is a fixed portfolio investment trust, separate portfolio trust and other entity whose governing instrument prevents varying the portfolio investments except to:
- Eliminate unsafe investments and investments not consistent with the preservation of the capital or the tax status of the investments of the fund;
- Honor redemption orders, meet anticipated redemption requirements, and negate gains from discount purchases;
- Maintain a constant net asset value per unit pursuant to, and in compliance with, an order or rule of the U.S. Securities and Exchange Commission;
- Reinvest the earnings from securities in like securities, or;
- Defray normal administrative expenses.
For federal income tax purposes, a nominee who holds the legal title to an account for another person (principal/beneficiary) and receives notification of the interest income belonging to the principal/beneficiary must include the interest income on the nominee’s return. The income is then removed from the nominee’s return by a reduction entry on the return. Pennsylvania allows the same treatment for personal income tax purposes. However, the Social Security number of the principal/beneficiary must be included on PA-40 Schedule A, Interest Income. Since nominee interest is included as an adjustment to the amount of federal interest income, the nominee amount taken for federal income tax purposes must be added back on Line 3 of PA-40 Schedule A, Interest Income, while the Pennsylvania nominee interest amount is deducted on Line 8 of PA-40 Schedule A.
Trust Other than a Business Trust
For Pennsylvania personal income tax purposes, if a trust, other than a business trust, invests in U.S. government obligations, then all the income from such obligations will retain their exempt status when passed through to the beneficiaries of the trust.
Distributions from IRC § 529 Qualified Tuition Programs for Non-Educational Purposes
If a taxpayer receives a distribution from a 529 plan for non-educational purposes, the distributions may be subject to Pennsylvania personal income tax as interest income. Refer to Personal Income Tax Bulletin 2006-04, Qualified Tuition Programs, for information regarding the taxation of distributions.
Distributions from IRC § 529A Achieving a Better Life Experience Savings Program Accounts
If a taxpayer receives a distribution from a 529A plan for non-qualifying purposes, the distributions may be subject to Pennsylvania personal income tax as interest income.
Distributions from Health or Medical Savings Accounts
If a taxpayer receives a distribution from a health or medical savings account that is included in federal taxable income, the amount taxable for federal income tax purposes is subject to tax as interest income for Pennsylvania personal income tax purposes.
Interest Income from PA S Corporations and Partnerships
Interest income reported on PA Schedules RK-1 is also reported as interest income for Pennsylvania personal income tax purposes.
Interest income reported on federal Schedules K-1 may be reported as interest income for Pennsylvania personal income tax purposes if PA Schedules RK-1 are not provided and the amount reported for federal income tax purposes does not include U.S. government interest. Tax-exempt interest income reported on federal Schedules K-1 may also be required to be included if the interest income is from obligations of other states. Refer to Tax-Exempt Interest in this chapter for additional information.
The Bottom Line
Investors put their money away for a number of reasons. Some do it to keep their money safe while others have a more lucrative reason in mind: to generate a return. This return may come in the form of a dividend, capital gain, or interest. Regardless of what form it takes, this is all counted as income. This means you must report it along with any other income sources during the tax year. If you have investments that pay you interest, be on the lookout for a Form 1099-INT from your financial institutions or investment firms after the end of January. This shows you how much interest you earned and what you need to report to the IRS.