The federal tax rate you'll pay on your interest income is fairly easy to determine – it’s your marginal tax rate. The government assesses different tax rates on different sources of investment income, including interest, dividends and capital gains. Many of these rates are complicated by requirements concerning when and how long you hold an income-generating security. Certain sources of interest income have special rules that may affect your tax liabilities.
Sources of Interest
Interest is a cash payment to reward you for keeping your money at a financial institution so that it can be loaned to others. A youngster opening her first savings account is introduced to interest at an early age. She might not realize that the bank loans her savings deposits to clients. Bonds and bond funds provide investors access to interest income from governments and corporations, domestic and foreign. In most cases, bonds pay cash interest one or more times a year, but exceptions abound. Interest from U.S. Treasury debt is free of state and local income taxes.
Interest at Maturity
All bonds accrue interest over time, but a few types wait to pay cash interest until bond maturity. Savings bonds pay interest when you cash the bonds, at which point you incur a federal-only tax liability on the interest income. Zero coupon bonds and Treasury bills are issued at a discount and do not pay interest until maturity. You owe tax on Treasury bill interest in the year the bill matures. Zero coupon bonds appreciate in value every year by an amount called the imputed interest. You do not receive this interest as cash until the bond is sold or matures, but you must pay income on imputed interest each year.
State and local municipalities can issue bonds that are free from federal and local income tax to residents of the issuing location. Local governments issue these bonds to fund projects for the public good, like dams or sewers. In high-tax locations such as New York City, triple tax-free municipal bonds are free from city, state and federal income tax to city residents. Municipal bonds pay relatively low interest rates, but their after-tax yields attract high-bracket investors.
Bond Fund Dividends
Stock and stock fund dividends may qualify for reduced taxed rates, but these breaks do not apply to bond fund dividends. Exchange-traded bond funds are stock issues backed by a basket of bonds. A fixed number of ETF shares trade on stock exchanges. Open-end bond mutual funds are investment pools that issue and redeem shares as needed. Both pay interest and capital gains in the form of dividends. You pay your marginal tax rate on the portion of bond fund dividends that arise from interest.
Individuals with modified adjusted gross income of $200,000 and couples with MAGI of $250,000 are subject to a Medicare surcharge of 3.8 percent, as of publication. The surcharge applies to the lesser of your interest income or the amount of MAGI that exceeds the noted thresholds. Interest income includes taxable income arising from interest. You exclude interest income from tax-free municipals when you figure your Medicare surcharge amount. Any income from retirement accounts is also exempt from the Medicare surcharge.
Foreign jurisdictions may assess U.S. residents a withholding tax that reduces the amount of bond interest received. When filing U.S. income taxes, you may apply for a foreign tax credit to partially or fully compensate for the foreign withholding taxes you pay.
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