What are the Tax Implications of Interest Income?

Interest on money and other assets is important not only to savers but also to investors who move money into some accounts to maintain liquidity. There are many good reasons for individuals and businesses to want to maintain a source of liquid funds for fast action in a troubled economy or to take advantage of a buying opportunity.

Interest that is Normally Taxed

Most interest income is taxed as ordinary personal income on tax returns in the year earned or realized. These interest sources include:

  • Some checking accounts
  • Ordinary savings accounts
  • Certificates of deposit
  • Interest on gifts to open accounts
  • Distributions from credit union accounts
  • Annuity contract interest
  • Income tax refund interest
  • Insurance dividends
  • Corporate bond interest
  • U.S. savings bonds interest is subject to federal income taxation
  • Withdrawn prepaid insurance premiums
  • Interest on the money you loan to others

There are some exceptions, but those sources of interest are usually reported as regular income on personal tax returns.

Interest Possibly Exempt from Taxes

There are bonds and bond funds that are exempt from federal income taxes, and in some cases, state and local income taxes. Bonds are of interest to many investors, though yields are lower than most stock market portfolios. This is due to the lower risk profile, and some of them enjoying tax exemption from federal, state, and local income taxes.

Municipal Bonds

Municipal bonds are issued by states and local governments to fund infrastructure, public works projects, hospitals, roads, bridges, etc. Housing authorities and port authorities also issue bonds. In general, the interest paid on municipal issues is exempt from federal taxes and sometimes state and local taxes.

Just judging municipal bonds on their yields can be misleading, particularly if you’re in a high tax bracket. For example, if your income tax rate is 24%, a municipal bond paying 5.75% interest is a better investment than a taxable bond paying interest at 7.57%. You can find online calculators to calculate taxable-equivalent yield, and you may find some tax-advantaged municipal bonds that are right for your portfolio.

Bonds are impacted by interest rate fluctuations, so many advisors recommend sticking to short to intermediate-term bonds to minimize interest rate risk.

Municipal Bond Funds

Even though municipal bonds have long been considered low-risk investments, watching the news over the past few years would tell you that municipalities are filing for bankruptcy at an increasing rate. Politicians borrow and spend, and sometimes it gets out of hand, especially with changing population demographics.

Investing in a municipal bond fund can reduce risk by diversifications among bonds by location, duration, and credit quality. Many investors in municipal bond funds seek conservative fixed income strategies.

Municipal bond funds can be an attractive option for their income and tax exemption. They are often held by high net worth investors in the higher tax brackets specifically for their exemption from federal and some state and local income taxes.

There are other reasons for seeking interest income other than just parking money for safety. Diversification, liquidity, and taxation should be considered in making interest income investment decisions.

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