Is Accrued Interest Taxable for Individuals?
Interest earned on investments can be taxable income before it's paid out. Learn the tax principles that determine when this income must be reported.
Accrued interest represents earnings on an investment or loan that have been recognized but not yet paid out. For individuals, the tax rules for this interest depend on the specific financial product and the principles governing when income is considered received for tax purposes. The Internal Revenue Service (IRS) has specific guidelines that determine when this accrued amount becomes taxable income. This can impact your annual tax liability even without an increase in your cash flow.
Key Tax Concepts for Accrued Interest
Two principles determine when you must pay taxes on accrued interest: constructive receipt and original issue discount. The concept of constructive receipt dictates that income is taxable when it is credited to your account or otherwise made available for you to withdraw without substantial restrictions. This means that even if you choose not to withdraw the interest from a savings account, it is still considered part of your taxable income for that year because you had the right to it.
The other principle is the Original Issue Discount, or OID. This applies to debt instruments, like certain bonds, purchased for a price less than their face value. The discount is a form of interest, and the IRS requires the bondholder to include a portion of the OID in their taxable income each year over the life of the bond.
Tax Treatment for Common Financial Products
Bank Accounts and Certificates of Deposit (CDs)
For savings accounts, checking accounts, and certificates of deposit (CDs), interest is taxable in the year it is made available to you under the principle of constructive receipt. When a financial institution credits your account with interest, it becomes taxable income regardless of whether you withdraw it. For CDs with terms longer than one year, any interest that is credited and could be withdrawn, even with a penalty, is taxed in that year.
U.S. Savings Bonds (Series EE and I)
U.S. Savings Bonds, specifically Series EE and Series I, offer a choice regarding when to report accrued interest for tax purposes. You can elect to report the increase in the bond’s value as interest income each year as it accrues. Alternatively, you can choose to defer reporting all the accumulated interest until the bond matures or you cash it in, whichever comes first. This deferral option provides flexibility in tax planning, allowing you to recognize the income in a more financially advantageous year.
Corporate and Zero-Coupon Bonds
Many corporate bonds and all zero-coupon bonds are issued with an Original Issue Discount (OID). The tax treatment for the accrued interest on these instruments follows the OID rules. Bondholders are required to include a portion of the total discount in their taxable income each year, even though they do not receive cash interest payments. The issuer of the bond calculates the amount of OID to be reported annually and provides this information to both the bondholder and the IRS.
Tax-Exempt Municipal Bonds
Interest income from bonds issued by states, cities, or counties is exempt from federal income tax. This exemption applies to the stated interest payments and any accrued interest. When a tax-exempt municipal bond is sold between interest payment dates, the portion of the sales price that represents accrued interest is tax-exempt for the seller. While this interest is federally tax-exempt, it may still be subject to state and local taxes.
How to Report Accrued Interest to the IRS
Information Gathering
Financial institutions report interest payments to you and the IRS. You will receive a Form 1099-INT for interest from sources like bank accounts and corporate bonds, or a Form 1099-OID for income from securities with an Original Issue Discount. These forms are sent by the end of January for the preceding tax year. On Form 1099-INT, the taxable interest to report is found in Box 1, while Form 1099-OID shows the amount to report in Box 1 or Box 8.
Reporting Procedure
When filing your federal income tax return, you must report all taxable interest income, even if you do not receive a Form 1099-INT or 1099-OID. If your total taxable interest income is over $1,500, you are required to complete Schedule B, Interest and Ordinary Dividends. On Part I of Schedule B, you will list each payer’s name and the amount of interest received from them. The total interest is then calculated on the form.
This total from Schedule B is transferred to the “Taxable Interest” line on your Form 1040. If your interest income is $1,500 or less, you do not need to file Schedule B and can report the total amount directly on Form 1040. Information from Form 1099-OID is combined with your other interest income and reported in the same manner.