Interest Income

Important Change

Reporting interest on your return.   Interest income that exceeds a certain amount must be reported on a separate schedule. For 2002, this amount has increased. If you file Form 1040A, you must now attach Schedule 1 to your return if your interest income is more than $1,500; if you file Form 1040, you must now attach Schedule B to your return if your interest income is more than $1,500. Before 2002, you had to attach Schedule 1 or Schedule B if your interest income was more than $400.

Important Reminder

Foreign-source income.   If you are a U.S. citizen with interest income from sources outside the United States (foreign income), you must report that income on your tax return unless it is exempt by U.S. law. This is true whether you reside inside or outside the United States and whether or not you receive a Form 1099 from the foreign payer.

Introduction

This chapter discusses:

• Different types of interest income,
• What interest is taxable and what interest is nontaxable,
• When to report interest income, and
• How to report interest income on your tax return.

In general, any interest that you receive or that is credited to your account and can be withdrawn is taxable income. (It does not have to be entered in your passbook.) Exceptions to this rule are discussed later in this chapter.

You may be able to deduct expenses you have in earning this income on Schedule A (Form 1040) if you itemize your deductions. See chapter 30.

Recordkeeping. You should keep a list showing sources and amounts of interest received during the year. Also, keep the forms you receive that show your interest income (Forms 1099-INT, for example) as an important part of your records.

Useful Items You may want to see:

Publication

• 537   Installment Sales
• 550   Investment Income and Expenses
• 1212   List of Original Issue Discount Instruments

Form (and Instructions)

• Schedule B (Form 1040)   Interest and Ordinary Dividends
• Schedule 1 (Form 1040A)   Interest and Ordinary Dividends for Form 1040A Filers
• 3115   Application for Change in Accounting Method
• 8815   Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989
• 8818   Optional Form To Record Redemption of Series EE and I U.S. Savings Bonds Issued After 1989

General Information

A few items of general interest are covered here.

Tax on investment income of a child under age 14.   Part of a child's 2002 investment income may be taxed at the parent's tax rate. This may happen if all the following are true.

1. The child was under age 14 at the end of 2002. A child born on January 1, 1989, is considered to be age 14 at the end of 2002.
2. The child had more than $1,500 of investment income (such as taxable interest and dividends) and has to file a tax return.
3. Either parent was alive at the end of 2002.

If all these statements are true, Form 8615, Tax for Children Under Age 14 Who Have Investment Income of More Than $1,500, must be completed and attached to the child's tax return. If any of these statements is not true, Form 8615 is not required and the child's income is taxed at his or her own tax rate.

However, the parent can choose to include the child's interest and dividends on the parent's return if certain requirements are met. Use Form 8814, Parents' Election To Report Child's Interest and Dividends, for this purpose.

For more information about the tax on investment income of children and the parents' election, see chapter 32.

Beneficiary of an estate or trust.   Interest you receive as a beneficiary of an estate or trust is generally taxable income. You should receive a Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc., from the fiduciary. Your copy of Schedule K-1 and its instructions will tell you where to report the income on your Form 1040.

Social security number (SSN).   You must give your name and SSN to any person required by federal tax law to make a return, statement, or other document that relates to you. This includes payers of interest.

SSN for joint account.   If the funds in a joint account belong to one person, list that person's name first on the account and give that person's SSN to the payer. (For information on who owns the funds in a joint account, see Joint accounts, later.) If the joint account contains combined funds, give the SSN of the person whose name is listed first on the account.

These rules apply both to joint ownership by a married couple and to joint ownership by other individuals. For example, if you open a joint savings account with your child using funds belonging to the child, list the child's name first on the account and give the child's SSN.

Custodian account for your child.   If your child is the actual owner of an account that is recorded in your name as custodian for the child, give the child's SSN to the payer. For example, you must give your child's SSN to the payer of dividends on stock owned by your child, even though the dividends are paid to you as custodian.

Penalty for failure to supply SSN.   If you do not give your SSN to the payer of interest, you may have to pay a penalty. See Failure to supply social security number under Penalties in chapter 1. Backup withholding also may apply.

Backup withholding.   Your interest income is generally not subject to regular withholding. However, it may be subject to backup withholding to ensure that income tax is collected on the income. Under backup withholding, the payer of interest must withhold, as income tax, a percentage of the amount you are paid. For 2003, the percentage is 30%.

Backup withholding may also be required if the Internal Revenue Service (IRS) has determined that you underreported your interest or dividend income. For more information, see Backup Withholding in chapter 5.

Reporting backup withholding.   If backup withholding is deducted from your interest income, the payer must give you a Form 1099-INT for the year that indicates the amount withheld. The Form 1099-INT will show any backup withholding as Federal income tax withheld.

Joint accounts.   If two or more persons hold property (such as a savings account or bond) as joint tenants, tenants by the entirety, or tenants in common, each person's share of any interest from the property is determined by local law.

Income from property given to a child.   Property you give as a parent to your child under the Model Gifts of Securities to Minors Act, the Uniform Gifts to Minors Act, or any similar law, becomes the child's property.

Income from the property is taxable to the child, except that any part used to satisfy a legal obligation to support the child is taxable to the parent or legal guardian having that legal obligation.

Savings account with parent as trustee.   Interest income from a savings account opened for a child who is a minor, but placed in the name and subject to the order of the parents as trustees, is taxable to the child if, under the law of the state in which the child resides, both of the following are true.

1. The savings account legally belongs to the child.
2. The parents are not legally permitted to use any of the funds to support the child.

Form 1099-INT.   Interest income is generally reported to you on Form 1099-INT, Interest Income, or a similar statement, by banks, savings and loans, and other payers of interest. This form shows you the interest you received during the year. Keep this form for your records. You do not have to attach it to your tax return.

Report on your tax return the total amount of interest income that you receive for the tax year. This includes amounts reported to you on Form 1099-INT and amounts for which you did not receive a Form 1099-INT.

Nominees.   Generally, if someone receives interest as a nominee for you, that person will give you a Form 1099-INT showing the interest received on your behalf.

If you receive a Form 1099-INT that includes amounts belonging to another person, see the discussion on nominee distributions under How To Report Interest Income in chapter 1 of Publication 550, or see the Schedule 1 (Form 1040A) or Schedule B (Form 1040) instructions.

Incorrect amount.   If you receive a Form 1099-INT that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form. The new Form 1099-INT you receive will be marked Corrected.

Form 1099-OID.   Reportable interest income may also be shown on Form 1099-OID, Original Issue Discount. For more information about amounts shown on this form, see Original Issue Discount (OID), later in this chapter.

Exempt-interest dividends.   Exempt-interest dividends you receive from a regulated investment company (mutual fund) are not included in your taxable income. (However, see Information-reporting requirement, next.) You will receive a notice from the mutual fund telling you the amount of the exempt-interest dividends that you received. Exempt-interest dividends are not shown on Form 1099-DIV or Form 1099-INT.

Information-reporting requirement.   Although exempt-interest dividends are not taxable, you must show them on your tax return if you have to file. This is an information-reporting requirement and does not change the exempt-interest dividends to taxable income.

Note.   Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. See Alternative Minimum Tax in chapter 31 for more information. Chapter 1 of Publication 550 contains a discussion on private activity bonds, under State or Local Government Obligations.

Interest on VA dividends.   Interest on insurance dividends that you leave on deposit with the Department of Veterans Affairs (VA) is not taxable. This includes interest paid on dividends on converted United States Government Life Insurance and on National Service Life Insurance policies.

Taxable Interest

Taxable interest includes interest you receive from bank accounts, loans you make to others, and other sources. The following are some other sources of taxable interest.

Dividends that are actually interest.   Certain distributions commonly called dividends are actually interest. You must report as interest so-called dividends on deposits or on share accounts in:

• Cooperative banks,
• Credit unions,
• Domestic building and loan associations,
• Domestic savings and loan associations,
• Federal savings and loan associations, and
• Mutual savings banks.

Money market funds.   Generally, amounts you receive from money market funds should be reported as dividends, not as interest.

Money market certificates, savings certificates, and other deferred interest accounts.   If you open any of these accounts, interest may be paid at fixed intervals of 1 year or less during the term of the account. You generally must include this interest in your income when you actually receive it or are entitled to receive it without paying a substantial penalty. The same is true for accounts that mature in 1 year or less and pay interest in a single payment at maturity. If interest is deferred for more than 1 year, see Original Issue Discount (OID), later.

Interest subject to penalty for early withdrawal.   If you withdraw funds from a deferred interest account before maturity, you may have to pay a penalty. You must report the total amount of interest paid or credited to your account during the year, without subtracting the penalty. See Penalty on early withdrawal of savings in chapter 1 of Publication 550, for more information on how to report the interest and deduct the penalty.

Money borrowed to invest in money market certificate.   The interest you pay on money borrowed from a bank or savings institution to meet the minimum deposit required for a money market certificate from the institution and the interest you earn on the certificate are two separate items. You must report the total interest you earn on the certificate in your income. If you itemize deductions, you can deduct the interest you pay as investment interest, up to the amount of your net investment income. See Interest Expenses in chapter 3 of Publication 550.

Example.   You deposited $5,000 with a bank and borrowed $5,000 from the bank to make up the $10,000 minimum deposit required to buy a 6-month money market certificate. The certificate earned $575 at maturity in 2002, but you received only $265, which represented the $575 you earned minus $310 interest charged on your $5,000 loan. The bank gives you a Form 1099-INT for 2002 showing the $575 interest you earned. The bank also gives you a statement showing that you paid $310 interest for 2002. You must include the $575 in your income. If you itemize your deductions on Schedule A (Form 1040), you can deduct $310, subject to the net investment income limit.

Gift for opening account.   If you receive noncash gifts or services for making deposits or for opening an account in a savings institution, you may have to report the value as interest.

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 interest. The value is determined by the cost to the financial institution.

Example.   You open a savings account at your local bank and deposit $800. The account earns $20 interest. You also receive a $15 calculator. If no other interest is credited to your account during the year, the Form 1099-INT you receive will show $35 interest for the year. You must report $35 interest income on your tax return.

Interest on insurance dividends.   Interest on insurance dividends left on deposit with an insurance company that can be withdrawn annually is taxable to you in the year it is credited to your account. However, if you can withdraw it only on the anniversary date of the policy (or other specified date), the interest is taxable in the year that date occurs.

Prepaid insurance premiums.   Any increase in the value of prepaid insurance premiums, advance premiums, or premium deposit funds is interest if it is applied to the payment of premiums due on insurance policies or made available for you to withdraw.

U.S. obligations.   Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes.

Treasury bills generally have a 4-week, 13-week, 26-week, or 52-week maturity period. They are issued at a discount in the amount of $1,000 and multiples of $1,000. The difference between the discounted price you pay for the bills and the face value you receive at maturity is interest income. Generally, you report this interest income when the bill is paid at maturity.

Treasury notes have maturity periods of more than 1 year, ranging up to 10 years. Maturity periods for Treasury bonds are longer than 10 years. Both notes and bonds generally pay interest every 6 months. Generally, you report this interest for the year paid. For more information, see U.S. Treasury Bills, Notes, and Bonds in chapter 1 of Publication 550.

For other information on Treasury notes or bonds, write to:

 

Bureau of the Public Debt
Attn: Customer Service and
Current Income Branch
Parkersburg, WV 26106-2186

Or, on the Internet, visit:
www. publicdebt.treas.gov

For information on series EE, series I, and series HH savings bonds, see U.S. Savings Bonds, later.

Interest on tax refunds.   Interest you receive on tax refunds is taxable income.

Interest on condemnation award.   If the condemning authority pays you interest to compensate you for a delay in paying an award, the interest is taxable.

Installment sale payments.   If a contract for the sale or exchange of property provides for deferred payments, it also usually provides for interest payable with the deferred payments. That interest is taxable when you receive it. If little or no interest is provided for in a deferred payment contract, part of each payment may be treated as interest. See Unstated Interest and Original Issue Discount in Publication 537, Installment Sales.

Interest on annuity contract.   Accumulated interest on an annuity contract you sell before its maturity date is taxable.

Usurious interest.   Usurious interest is interest charged at an illegal rate. This is taxable as interest unless state law automatically changes it to a payment on the principal.

Individual retirement arrangements (IRAs).   Interest on a Roth IRA generally is not taxable. Interest on a traditional IRA is tax deferred. You generally do not include it in your income until you make withdrawals from the IRA. See chapter 18.

Interest income on frozen deposits.   Exclude from your gross income interest on frozen deposits. A deposit is frozen if, at the end of the year, you cannot withdraw any part of the deposit because:

1. The financial institution is bankrupt or insolvent, or
2. The state where the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent.

The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of:

1. The net amount you withdrew from these deposits during the year, and
2. The amount you could have withdrawn as of the end of the year (not reduced by any penalty for premature withdrawals of a time deposit).

If you receive a Form 1099-INT for interest income on deposits that were frozen at the end of 2002, see Frozen deposits under How To Report Interest Income in chapter 1 of Publication 550, for information about reporting this interest income exclusion on your tax return.

The interest you exclude is treated as credited to your account in the following year. You must include it in income when you can withdraw it.

Example.   $100 of interest was credited on your frozen deposit during the year. You withdrew $80 but could not withdraw any more as of the end of the year. You must include $80 in your income for the year. You must exclude $20.

Bonds traded flat.   If you buy a bond when interest has been defaulted or when the interest has accrued but has not been paid, that interest is not income and is not taxable as interest if paid later. When you receive a payment of that interest, it is a return of capital that reduces the remaining cost basis. Interest that accrues after the date of purchase, however, is taxable interest income for the year it is received or accrued. See Bonds Sold Between Interest Dates, later, for more information.

Below-market loans.   A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. See Below-Market Loans in chapter 1 of Publication 550 for more information.

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