Taxable vs. Tax-Exempt Interest

Interest income is one of the most common forms of investment income you'll encounter as a tax professional. Understanding which interest is taxable, which is tax-exempt, and the special rules that apply to each type is critical for the EA exam.

The General Rule

All interest income is taxable unless specifically excluded by law. When you receive interest, you must include it in gross income unless a specific provision of the Internal Revenue Code exempts it. The primary exception is municipal bond interest, which is generally exempt from federal income tax.

Form 1099-INT: Interest Income Reporting

Financial institutions must issue Form 1099-INT to anyone receiving $10 or more in interest during the tax year. Even if you don't receive a 1099-INT, you must still report all taxable interest.

Filing threshold: If your total taxable interest exceeds $1,500, you must complete Schedule B and attach it to your Form 1040.

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Taxable Interest Income

Bank Accounts and CDs

Interest earned from the following sources is fully taxable at ordinary income rates:

• Savings accounts and money market accounts
• Certificates of deposit (CDs) - interest is taxable in the year credited, even if not withdrawn
• Credit union share accounts
• Money market mutual funds (distributed as dividends but taxable as interest)

Timing rule for CDs: Interest on CDs is taxable when credited to your account, not when you cash the CD. If you cash a CD early and pay a penalty, the penalty is an above-the-line deduction on Schedule 1.

U.S. Treasury Securities

Interest from Treasury bills, notes, and bonds has a special tax treatment:

This makes Treasury securities attractive for taxpayers in high-tax states like California and New York.

Treasury Bill Interest: T-bills are sold at a discount and pay face value at maturity. The difference between purchase price and face value is interest income, reported in the year of maturity.

Form 1099-INT Reporting: Treasury interest appears in Box 3, separate from other interest in Box 1.

Corporate Bonds

Interest from corporate bonds is fully taxable at the federal, state, and local level. This includes:

• Investment-grade corporate bonds
• High-yield (junk) bonds
• Convertible bonds
• Bond mutual funds and ETFs (to the extent they hold corporate bonds)

Other Taxable Interest

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Tax-Exempt Interest: Municipal Bonds

Municipal bonds (also called "munis") are debt obligations issued by state and local governments. Their interest is generally exempt from federal income tax.

Types of Tax-Exempt Municipal Bonds

Reporting Requirement: Form 1040, Line 2a

Even though municipal bond interest is tax-exempt, you must still report it on Line 2a of Form 1040. This serves several purposes:

• Used to calculate Social Security benefit taxation
• Used for Medicare premium surcharges (IRMAA)
• Required for some state tax calculations
• Informs various income-based phase-outs

Private Activity Bonds and AMT

Private activity bonds fund projects with substantial private use (stadiums, airports, industrial parks). While the interest is federally tax-exempt under regular tax rules, it's an adjustment for Alternative Minimum Tax (AMT).

2024 AMT Thresholds:

Which bonds are subject to AMT?

• Private activity bonds (except housing and 501(c)(3) bonds)
• Certain industrial development bonds
• Bonds for airports and ports with substantial private use

Which bonds are NOT subject to AMT?

• Single-family mortgage revenue bonds
• Multifamily housing bonds
• Qualified 501(c)(3) bonds (nonprofits)
• Governmental bonds

Tip: Bond prospectuses and Form 1099-INT Box 9 indicate whether interest is subject to AMT.

Triple Tax-Free Bonds

Triple tax-free means the bond interest is exempt from federal, state, AND local income taxes. This typically occurs when you purchase municipal bonds issued by your own state or municipality.

Example: A New York resident holding New York State bonds pays:

• Federal tax: $0 (exempt as municipal bond)
• New York State tax: $0 (exempt for residents)
• New York City tax: $0 (exempt for residents)

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Series EE and I Savings Bonds

U.S. Savings Bonds have unique tax treatment that differs from Treasury securities.

Interest Accrual Methods

Taxpayers can report savings bond interest using either method:

Election: Once you choose to report annually, you must continue for all savings bonds and cannot change without IRS consent. Most taxpayers use the cash method, deferring tax until redemption.

Education Savings Bond Program (Form 8815)

Series EE and I bonds purchased after 1989 may qualify for the education tax exclusion. This allows you to exclude the interest from income when bonds are redeemed to pay for qualified higher education expenses.

Requirements:

• Bond owner must be at least 24 years old at issuance
• Bonds must be in owner's name (not the student's) or jointly with spouse
• Proceeds used for qualified education expenses (tuition, fees—not room/board)
• Used for owner, spouse, or dependent

2024 Income Phase-Out Limits (MAGI):

If MAGI exceeds the phase-out limits, the exclusion is partially or fully lost.

Form 8815 is used to calculate and claim the exclusion. The calculation considers:

1. Qualified education expenses
2. Bond proceeds (principal + interest)
3. Other educational assistance received
4. Modified AGI for phase-out

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Below-Market Loans and Imputed Interest

When a loan carries below-market interest (interest rate less than the Applicable Federal Rate or AFR), the IRS imputes interest income to the lender and a corresponding interest deduction to the borrower.

Applicable Federal Rates (AFR)

The IRS publishes AFRs monthly for three term categories:

2024 Example AFRs (varies monthly): Short-term ~4.78%, Mid-term ~4.21%, Long-term ~4.36%

Exceptions to Imputed Interest Rules

$10,000 De Minimis Exception:

• Loans of $10,000 or less are exempt from imputed interest rules
• All loans between the parties are aggregated
• Exception does NOT apply if proceeds are used to buy income-producing assets

$100,000 Exception for Gift Loans:

• For gift loans between individuals of $100,000 or less
• Imputed interest limited to borrower's net investment income
• If borrower's net investment income is $1,000 or less, imputed interest is zero

Types of Below-Market Loans

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Interest on State Tax Refunds

Interest paid on state income tax refunds requires careful analysis.

When Is State Refund Interest Taxable?

State tax refund interest is always taxable as ordinary interest income. However, the tax benefit rule determines whether the refund itself is taxable.

The refund is taxable if:

1. You itemized deductions in the year you paid the tax, AND
2. You received a tax benefit from the state tax deduction

The refund is NOT taxable if:

1. You took the standard deduction in the prior year, OR
2. You elected to deduct sales tax instead of income tax, OR
3. The state tax deduction provided no tax benefit (e.g., you were in AMT)

Form 1099-G: States issue Form 1099-G for refunds over $10 (Box 2) and interest over $600 (or reported on Form 1099-INT).

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Summary: Interest Income Comparison