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Reporting Interest Income on Your Income Tax Return

Edward A. Zurndorfer, Certified Financial Planner

Those individuals who receive interest income of any type -- taxable or nontaxable (tax-exempt) -- must report the income on their federal income tax returns. Taxable interest income includes amounts reported to individuals on Form 1099-INT and reported on Form 1040, line 8a. Tax-exempt interest (also reported on Form 1099-INT) includes municipal bond interest and exempt-interest dividends from a mutual fund or other regulated investment company and reported on IRS Form 1040, line 8b.

The question has often been asked: Why must tax-exempt interest income be reported on a tax return? The IRS requires reporting of tax-exempt interest because: (1) tax-exempt income is one of the factors used to determine the amount of Social Security benefits that are includable in gross income; (2) tax-exempt income alerts IRS that there may be unreported alternative minimum tax (AMT) liability for tax-exempt (for regular tax purposes) "private activity bonds" interest income; and (3) tax-exempt income assists the IRS in selecting returns for audit.

In addition to reporting interest income on Form 1040 lines 8a and 8b, those individuals with total interest income exceeding $1,500 during the year must be report all interest income received on Schedule B (Form 1040-A filers with interest income exceeding $1,500 must also file Schedule B). Other situations requiring an individual to file Schedule B are: (1) the individual is excluding interest from Series EE bonds issued after 1989; or (2) the individual is the recipient of interest income related to any of the following situations: seller-financed mortgage, nominee distribution, original issue discount adjustments or amortizable bond premiums. Some of these situations are discussed below.

The IRS occasionally sends out to individuals Notice CP-2000 (Notice of Underreported Income) when interest income or other type of income reported on an individual's tax return does not match the official documents the IRS received from banks, credit unions or brokerages. When preparing their 2010 income tax returns, individuals should review and take into consideration every interest-bearing bank, credit union or brokerage account that they may have owned during 2010. They should look at their final account statement(s) for 2010 - most probably the statement issued in late December 2010 or early January 2011 - that shows year-to-date interest income paid in the account during 2010. The year-to-date interest income should be compared to what is shown on the 1099-INT issued by the bank, credit union or brokerage. If the amount is correct, then that amount will be reported on the individual's tax return. If the amount is not correct, then the account owner should contact the 1099-INT issuer and find out why there is a difference. A bank or credit union is not required to issue a 1099-INT if the total interest paid during the year in all accounts owned is less than $10. However, the account owner is obligated to report the interest income on Form 1040 line 8a or 8b even if the total interest received during the year was less than $10.

Nominee Interest

If an individual receives a Form 1099-INT with interest income for the year reported in his or her name and Social Security number but the interest income was received by another individual, then the individual who received the incorrect 1099-INT must report the full amount reported on Form 1099-INT on Schedule B. But on a separate line on Schedule B (below the total of all interest reported) the "nominee interest" received should be reported as "nominee distribution" and subtracted from the total interest income reported. But whichever bank, credit union or brokerage issued the Form 1099-INT to the wrong recipient must reissue a new 1099-INT with the actual recipient's name and Social Security number and send the correct 1099-INT to the actual recipient.

Certificates of Deposit

Interest earned on certificates of deposits (CDs) is taxable in the year it is earned, even though the interest earned is not withdrawn until a later year. One exception to this rule is for CDs maturing in one year or less. The interest earned on these CDs is recognized when the CDs mature. This rule enables those CD owners to defer income recognition until the interest income is actually received. The same rule applies to U.S. Treasury bills which have maturities of four weeks, three months and six months.

Money Market Funds

Income received from money market fund accounts should be reported as dividend income and not as interest income.

Insurance Dividends

Interest on insurance dividends left on deposit with an insurance company that can be withdrawn annually is taxable in the year it is credited to the account. The only exception is interest paid that can be withdrawn only on the anniversary date of the policy or other specified date. In that case, the interest is taxable in the year the anniversary date occurs.

Tax Refunds

While federal income tax refunds are not taxable, interest paid on these refunds is fully taxable for federal income tax purposes.

Nontaxable Interest Income

Any interest income credited to bank deposits that could not be withdrawn because the income was associated with "frozen deposits" is considered as nontaxable income. A frozen deposit is a deposit in which all or part of the bank account cannot be withdrawn due to financial institution bankruptcy or insolvency.

Interest on insurance dividends left on deposit with the Department of Veterans Affairs (VA) is not taxable. This includes interest paid on dividends on converted U.S. Government Life Insurance polices and on National Service Life Insurance policies.

Original Issue Bonds

When a debt security such as a bond is issued at less than the stated redemption value, the difference is referred to as original issue discount (OID). The OID is reported on Schedule B with other interest income. Here is an example.

Harry paid $9,000 for a bond that at maturity will yield $10,000. The $1,000 difference between the purchase price and the yield is OID interest income. On Form 1040 line 8a or 8b and perhaps Schedule B, Harry will include the ratable portion of any interest income (OID) earned during the year. Note that the $1,000 is not capital gain income. If Harry holds the bond to maturity his cost basis in the bond will be $10,000.

Accrued Interest on Bonds

If a bond is paid between interest payment dates, part of the sale price represents interest accrued to the date of sale. The following summarizes how the seller of the bond and the purchaser of the bond report the accrued interest.

Seller. The seller reports the accrued income in gross income. Reporting the accrued interest increases the bond's cost basis.

Purchaser. The purchaser deducts the accrued interest from the next interest payment. On Schedule B, the purchaser reports the total interest received, and on a separate line lists "accrued interest" and subtracts the accrued interest from the total interest. But the cost basis of the bond is not included in the amount of the accrued interest.

Consider the following example:

Seller (S) purchased a bond for $5,000. On May 31, 2010, S sells the bond and receives $5,300. The $5,300 includes $200 of interest income that accrued between January 1 and May 31, 2010. S will report on the 2010 tax return interest income of $200 and $100 of capital gain income.

Purchaser (P) purchased the bond sold by S for $5,300. During 2010, P received $450 of interest income. P will report on the 2010 tax return $250 of interest income ($450 total interest less $200 accrued interest income). The bond cost basis is $5,000 plus $100 or $5,100 ($5,300 minus the $200 of interest income that accrued between January 1 and May 31, 2010).

Posted: 3/2/2011

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  He is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.