During 2022 market interest rates increased, and many federal employees and retirees received larger amounts of interest income during 2022 compared to what they received in interest income in previous years. Taxable interest income (as reported to the recipient in Box 1 of Form 1099-INT, see below) is reported on IRS Form 1040-line 2b while tax-exempt interest (this includes municipal bond interest and exempt interest dividends from a mutual fund) are reported on line 2a of Form 1040, as shown here:
The IRS requires reporting of tax-exempt interest on line 2a of Form 1040 (as reported to the recipient in Box 8 of Form 1099-INT, see below) because:
• Tax-exempt income is a factor to determine the amount, if any, of Social Security benefits includable in gross income
• Interest expense incurred to purchase or carry tax-exempt obligations is not deductible, and
• There may be an alternative minimum tax (AMT) liability for tax-exempt private activity bonds interest, reported in Box 9 of Form 1099-INT (see below).
An individual is required to also attach Schedule B to Form 1040 to report interest income under the following circumstances:
(1) The total interest earned during 2022 was over $1,500;
(2) The individual qualifies and is excluding interest received from Series EE bonds issued after 1989 or Series I bonds when the bonds were redeemed and used to pay higher education expenses,
(3) The individual has received income from a seller-financed mortgage;
(4) The individual has nominee distribution interest income; or
(5) The individual has original issue discount adjustments or amortizable bond premium.
Accrued Interest on Bonds
If a bond is sold between interest payment dates, part of the sales price represents interest accrued up to the date of sale. The seller of the bond must report the accrued interest in gross income as interest, and report any gain as capital gain income. The following example illustrates:
Example 1. Jennifer sold an 8 percent annual yielding bond costing her $5,000 on May 31,2022 for $5,300. The sale proceeds include $200 of interest income accrued from January 1 to May 31,2022 that she will report on Schedule B. She will also report $100 of capital gain income on Schedule D (Capital Gains and Losses).
Certificates of Deposit
Interest earned on certificates of deposit (CDs) and similar accounts is taxable as it is earned, even though the interest earned is not withdrawn until a later year. The exception are CDs which mature in one year or less. In that case, the interest income is recognized when the CDs mature. This enables individuals to defer income recognition until the year the interest income is received. The same rule applies to US Treasury Bills (issued by the Treasury Department Bureau of the Public Debt). US Treasury Bills are issued in durations of 13 weeks, 26 weeks or 52 weeks. The following examples illustrate:
Example 2. William purchased a two-year $10,000 CD on July 1, 2022. The CD pays 3 percent annual interest and will mature on June 30, 2024. For the year 2022 the CD accrued $150 of interest (3 percent of $10,000 per year or $300 of interest income; in half a year July 1, 2022 through December 31, 2022 there is $150 of accrued interest income that William must report as taxable interest income on his 2022 federal income return.
Example 3. Sharon purchased a one-year $10,000 CD on July 1, 2022. The CD pays 1.50 percent and matures on June 30, 2023. Sharon will receive the $150 interest income on July 1, 2023. She does not have to report the $75 of interest income she accrued between July 1,2022 and December 31,2022 on her 2022 federal income tax return. Sharon will report the $150 of interest income she received on July 1, 2023 on her 2023 federal income tax return.
Note that another difference between CD interest income and US Treasury obligation (Treasury Bills, Treasury Notes, and Treasury Bonds) is that CD interest income is subject to both Federal and state income tax while US Treasury obligation interest is subject only to Federal Income tax.
Money Market Funds
Amounts received from money market funds should be reported as dividend income and not as interest income. This includes dividends on money market funds paid by credit unions, domestic building loan and savings institutions, Federal savings and loan institutions, and mutual savings banks.
US Savings Bonds
Those individuals who use the cash method of accounting (most individuals do) generally report the interest on US Savings bonds when they redeem the bonds. The three types of US Savings bonds are discussed here:
• Series E bonds. Series E bonds were issued before 1980. All Series E bonds have matured and are no longer earning interest. For all Series E bonds, the purchase price and accrued interest is payable to the Series E bond owner when the bond is redeemed. The difference between the purchase price and the redemption value is taxable interest and subject only to federal income tax.
• Series EE bonds. Series EE bonds were first offered in January 1980 and have a maturity period of 30 years. They were offered in paper (definitive) form until 2012. Paper Series EE and Series E bonds were issued at a 50 percent discount. For example, a $100 Series EE bond issued in paper form was purchased for $50. The bond increased in value as they earned interest. Electronic (book-entry) Series EE bonds were first offered in 2003. They are issued at face value and increase in value as they earn interest. For all Series EE bonds, the purchase price, plus all accrued interest, is payable to the Series EE bond owner when the bond is redeemed. The difference between the purchase price and the redemption value is taxable interest and only subject to federal income tax.
• Series I bonds. Series I bonds were first offered in 1998. These are inflation-indexed bonds issued at face value with a maturity of 30 years. Series I bonds increase in value as they earn interest. The face value, plus all accrued interest, is payable to the Series I bond owner at redemption. The difference between the purchase price and the redemption value is taxable interest and only subject to federal income tax.
The following table summarizes who pays the tax on U.S. Savings Bond Interest.
Who Pays the Tax on U.S. Savings Bond Interest
Other Taxable Income
The following items are taxable as interest income:
1. Insurance dividends. Interest paid on dividends left on deposit with an insurance company that can be withdrawn annually is taxable in the year that the interest is credited to the account. This is unless the dividends can be withdrawn only on the anniversary date of the policy (or other specified date) in which case the interest is taxable in the year the anniversary date occurs.
2. Tax refunds. Interest on tax refunds is federally taxable, if interest is paid on a federal income tax return, and is both federally and state taxable if the interest is paid on a state tax refund.
3. Gift for opening an account. For deposits of less than $5,000, gifts or services valued at more than $10 must be reported as interest. For deposits of $5,000 or more, gifts or services valued at more than $20 must be reported as income. The value is determined by the cost to the financial institution.
The following items are nontaxable:
• Frozen deposits. Excluded as income to the extent credited interest was neither withdrawn nor able to be withdrawn at the end of the year. A frozen deposit is a deposit all or part of which cannot be withdrawn due to financial institution bankruptcy or insolvency.
• VA dividends. Interest on insurance dividends left on deposit with the Department of Veteran Affairs (VA) is not taxable.