Taxpayers who desire current cash flows from their investments may choose investments that generate interest or regular dividends. Investments generating interest income in- clude certificates of deposit (CDs), savings accounts, corporate bonds, and governmen- tal bonds. Investments generating dividend income include direct equity investments in corporate stocks and investments in mutual funds that invest in corporate stock.1 Although all these investments generate current cash flows, they differ significantly in terms of their economic and tax consequences.
By lending money to banks, governmental entities, or corporations, investors essen- tially become debt holders. As such, they are legally entitled to receive periodic interest payments and to recover the amount of principal loaned. In the case of bonds, the principal is the maturity value or face value of the bonds. Interest payments and the time and man- ner of repayment of the loan principal are defined either contractually for CDs and savings accounts, or by bond covenants for loans made either to governments or corporations.
In contrast, investors who purchase stocks become shareholders (also called equity holders) of a corporation. As shareholders, they are entitled to receive dividends if the
LO 7-1
1Mutual funds are portfolios of investment assets managed by professional money managers. Generally, the income earned by mutual funds flows through to the owners of mutual fund shares who pay the resulting taxes due. The nature of the assets held by the mutual fund determines the character of the income.
THE KEY FACTS Investments Overview
• After-tax rate of return of investment depends on
• Before-tax rate of return.
• When investment income and gains are taxed.
• Taxed annually
• Tax deferred
• Tax-exempt
• When investment losses are deducted.
• Deduction annually
• Deduction deferred
• Rate at which invest- ment income or gains/
expenses or losses are taxed/deducted.
• Ordinary tax rates
• Preferential tax rates
• Zero tax rate
THE KEY FACTS Interest and Dividend
Income
• Interest
• Interest is taxed at ordi- nary rates.
• Cash interest payments are taxed annually.
• Accrued market discount is taxed at sale or maturity.
• Savings bonds are taxed at sale or maturity.
• Original issue discount is taxed annually.
• Dividends
• Dividends are taxed annually.
• Qualified dividends are taxed at preferential rates.
company declares dividends and to indirectly share in either the future appreciation or depreciation in the value of a corporation through stock ownership. Unlike debt hold- ers, shareholders are not legally entitled to receive dividend payments or to recover their initial investment. Thus, from an investor’s perspective, debt tends to be less risky than equity.
For tax purposes, individual investors typically are taxed on both interest and divi- dend income when they receive it. However, interest income is taxed at ordinary rates, while dividend income is generally taxed at lower capital gains rates.
Interest
In general, taxpayers recognize interest income from investments when they receive the interest payments.2 Taxpayers investing in savings accounts, money market accounts, CDs, and most bonds receive interest payments based on a stated annual rate of return at yearly or more frequent intervals.
Special rules apply for determining the timing and amount of interest from bonds when there is a bond discount—that is, when bonds are issued at an amount below the maturity value—or a bond premium—that is, when bonds are issued at an amount above the maturity value. Below we discuss these rules as they apply to corporate, U.S. Treasury bonds, and U.S. savings bonds.
Corporate and U.S. Treasury Bonds Both corporations and the U.S. Treasury raise money from debt markets by issuing bonds.3 Corporate bonds, Treasury bonds, and Treasury notes are issued at maturity value, at a discount, or at a premium, depending on prevailing interest rates.4 Treasury bonds and Treasury notes pay a stated rate of interest semiannually.5 However, corporate bonds may pay interest at a stated
“coupon” rate, or they may not provide any periodic interest payments. Corporate bonds that do not pay periodic interest are called zero-coupon bonds. Overall, the con- sequences of holding corporate or Treasury bonds are very similar. The two primary differences are that (1) interest from Treasury bonds is exempt from state taxation while interest from corporate bonds is not, and (2) Treasury bonds always pay inter- est periodically while corporate bonds may or may not. The tax rules for determining the timing and amount of interest income from corporate and U.S. Treasury bonds are as follows:
• Taxpayers include the actual interest payments they receive in gross income.
• If the bond was issued at a discount, special original issue discount (OID) rules apply. Taxpayers are required to amortize the discount and include the amount of the current year amortization in gross income in addition to any interest pay- ments the taxpayer actually receives.6 In the case of corporate zero-coupon bonds, this means taxpayers must report and pay taxes on income related to the bonds even though they did not receive any payments from the bonds. Bond issuers or brokers are responsible for calculating the yearly amortization of the original issue discount and providing this information to investors using Form 1099-OID.
2Interest income is reported on Part I of Schedule B filed with taxpayers’ Form 1040.
3Investors in corporate bonds assume more risk than investors in Treasury securities because they are relying on the creditworthiness of the corporation issuing the bonds. To compensate bondholders for this additional risk, corporate bonds usually yield higher before-tax rates of return than Treasury securities.
4The bonds are issued at a discount (premium) if the market interest rate is higher (lower) than the stated rate on the bonds.
5Treasury notes and bonds differ in terms of their maturities. Treasury notes are issued with 2-, 5-, and 10-year maturities. In contrast, Treasury bonds are issued with maturities greater than 10 years. From this point forward, we use the term Treasury bonds to refer to both Treasury notes and Treasury bonds.
6§1272. Original issue discount is amortized semiannually under the constant yield method, which is consis- tent with the approach used to amortize bond discount under GAAP.
• If the bond was issued at a premium, taxpayers may elect to amortize the premium.7 Taxpayers or their advisers are responsible for determining the yearly amortization of bond premium if the election to amortize the premium has been made. The amount of the current year amortization offsets a portion of the actual interest payments that taxpayers must include in gross income. The original tax basis of the bond includes the premium and is reduced by any amortization of bond premium over the life of the bond.
• If the bond is purchased in the secondary bond market at a discount, the taxpayer treats all or some of the market discount as interest income when she sells the bond or the bond matures.8 If the bond is sold prior to maturity, a ratable amount of the market discount (based on the number of days the bond is held over the num- ber of days until maturity when the bond is purchased), called the accrued market discount, is treated as interest income on the date of sale.9 If the bond is held to maturity, the entire bond discount is treated as interest income at maturity.
• If the bond is purchased in the secondary bond market at a premium, the premium is treated exactly like original issue bond premiums. As a result, the taxpayer may elect to amortize the market premium to reduce the annual interest income re- ceived from the bond. Otherwise, the premium remains as part of the tax basis of the bond and affects the capital gain or loss the taxpayer recognizes when the tax- payer sells or redeems the bond.
U.S. Savings Bonds U.S. savings bonds such as Series EE or Series I bonds are is- sued at either face value or at a discount. These bonds do not pay periodic interest; rather, interest accumulates over the term of the bonds and is paid when investors redeem them at maturity or earlier.10 That is, the amount of interest income taxpayers recognize when they redeem the bonds is the excess of the bond proceeds over the taxpayer’s basis in the bonds, meaning its purchase price. Taxpayers may elect to include the increase in the bond redemption value in their income each year, but this is generally not advisable because it accelerates the income from the bond without providing any cash to pay the taxes.11 Finally, interest from Series EE and Series I bonds may be excluded from gross income to the extent the bond proceeds are used to pay qualifying educational expenses.
However, this exclusion benefit is subject to phase-out based on the taxpayer’s AGI.
What if: Assume that Courtney was deciding whether to invest the $50,000 earmarked for the Park City vacation home in (1) Series EE savings bonds that mature in exactly five years, (2) original issue AMD Corporation zero-coupon bonds that mature in exactly five years, or (3) U.S. Treasury bonds that pay $46,250 at maturity in five years trading in the secondary bond market with a stated annual inter- est rate of 10 percent. Further, assume that all bonds yield 8 percent annual before-tax rates of return compounded semiannually. At the end of the first year, (1) the redemption value of the EE savings bonds would be $54,080, or (2) Courtney would receive a Form 1099-OID from AMD reporting
Example 7-1
7§171. Like an original issue discount, a bond premium is amortized semiannually under the constant yield method—the same method used to amortize bond premiums under GAAP. Unlike premiums on taxable bonds, premiums on tax-exempt bonds must always be amortized.
8§1276(a). Under §1278(b)(1), taxpayers may elect to include the amortization of market discount in their income annually. However, this election accelerates the recognition of income from the market discount and is therefore usually not advisable.
9§1276(b).
10Series EE savings bonds are issued at a discount and Series I savings bonds are issued at maturity value.
EE bonds provide a constant rate of return while Series I bonds provide a return that is indexed for inflation and thus increases over time.
11§454(a). Investors that make this election report the annual increase in the redemption value of their savings bonds using savings bond redemption tables published by the Treasury Department.
$4,080 of OID amortization for the year, or (3) she would receive two semiannual interest payments of
$2,312.50 from the Treasury bonds. Under the general rules, how much interest income from each bond would Courtney report at the end of the first year?
Answer: $0 from the Series EE savings bonds, $4,080 from the AMD bonds, and $4,625 (two semian- nual payments of $2,312.50) from the Treasury bonds. Note, however, that Courtney could elect to include the $4,080 increase in redemption value of the Series EE bonds in interest income even though she did not receive any interest payments on the bonds (probably not optimal). She also could elect to amortize $637.50 of the $3,750 premium ($50,000 purchase price less the $46,250 maturity value) on the Treasury bonds to offset the $4,625 in actual interest payments she received on the bonds (probably a good idea). The calculations required to amortize the premium on the Treasury bonds for the first year are reflected in the following table:
(A)
Adjusted Basis (B) (C)
of Bonds at Interest Received Interest Premium Semiannual Beginning of and Reported Earned Amortization Period Semiannual Period ($46,250 × 10% × .5) (A) × 8% × .5 (B) − (C)
1 $50,000.00 $2,312.50 $2,000.00 $312.50
2 49,687.50 2,312.50 1,987.50 325.00
Yearly Total 4,625.00 3,987.50 637.50
Intuitively, would Courtney be better or worse off purchasing the Series EE savings bonds rather than a corporate bond to save for the Park City home?
Answer: Courtney would be better off purchasing the Series EE savings bonds in two respects. First, she wouldn’t have to pay state income taxes on the interest earned from the savings bonds. Second, she would be able to defer paying taxes on the accumulated interest from the savings bonds until the savings bonds are cashed in at maturity.
Intuitively, would Courtney be better or worse off purchasing the AMD zero-coupon bonds rather than a corporate bond to save for the Park City home?
Answer: She would be worse off because she would have to pay taxes currently from the OID amor- tization on the AMD bonds without receiving any cash flow from the bonds to pay the taxes due.
What if: Assume that on January 1, Courtney used the $50,000 earmarked for the Park City vacation home to purchase AMD zero-coupon bonds in the secondary bond market almost immediately after the bonds were originally issued. If they mature in exactly five years and have a maturity value of $74,000, how much interest income will Courtney report at the end of the first year and in the year the bonds mature?
Answer: $0 in the first year and $24,000 in the year the bonds mature. Because the AMD zero- coupon bonds were not purchased at original issue, the entire $24,000 market discount on the bonds will be reported as interest income when the bonds mature. Thus, Courtney will not report any income related to the AMD bonds until the year the bonds mature.
What if: Assume the same facts as above, except Courtney purchased U.S. Series EE bonds instead of AMD zero-coupon bonds to fund the Park City vacation home in five years. How much interest in- come will she report at the end of the first year and in the year the bonds mature?
Answer: $0 in the first year and $24,000 in the year the EE savings bonds mature. This is exactly the same outcome as the investment in the AMD zero-coupon bonds (ignoring possible state income tax effects).
Example 7-2
As our discussion suggests, for certain types of investments such as savings accounts, money market accounts, and CDs, computing the annual taxable interest income is rela- tively straightforward. However, for investments in bonds, the process is much more in- volved. Exhibit 7-1 summarizes the general rule and exceptions for the timing of interest payments and related tax payments.
Dividends
Historically, dividends received by investors have been taxed at the same rate as interest income; however, in 2003 Congress changed the law for dividends to mitigate the so-called “double tax” on dividend income.12 Consistent with the general rule for taxing interest income, dividend payments (including reinvested dividends) are taxed annually.13 However, as we discuss in the Individual Income Tax Computation and Tax Credits chap- ter, qualified dividends are taxed at a preferential rate: 0, 15, or 20 percent, depending on the taxpayer’s filing status and amount of taxable income.14 Qualified dividends are those paid by domestic or certain qualified foreign corporations provided investors hold the dividend-paying stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date, the first day on which purchasers of the stock would not be entitled to receive a declared dividend on the stock.15 Exhibit 7-2 illustrates the 121-day period surrounding the ex-dividend date.
Nonqualified dividends are not eligible for the reduced rate and are therefore taxed at ordinary rates. Corporations report the amounts of the dividends and indicate whether the dividends are potentially eligible for the preferential rate when they send Form 1099-DIV to shareholders after year-end. However, shareholders ultimately must determine whether they qualify for the preferential rate by confirming they held the stock for the required number of days around the ex-dividend date.
EXHIBIT 7-2 Holding Period for Qualified Dividends Ex-dividend day
121-day period
60 days 60 days
12Because corporations pay income taxes, dividends are taxed once at the corporate level, when the in- come used to pay dividends is earned by the corporation, and a second time when dividends are received by investors.
13Dividends are reported on Part II of Schedule B filed with taxpayers’ Form 1040.
14The tax rate for qualified dividends follows the capital gains tax rates as discussed later in this chapter.
15Qualified foreign corporations are those incorporated in a U.S. possession (e.g., Puerto Rico, U.S. Virgin Islands), those eligible for the benefits of a comprehensive income tax treaty with the United States, or those whose shares are readily traded on an established U.S. securities market.
EXHIBIT 7-1 Timing of Interest Payments and Taxes
General Rule Exception Exception
Interest Received Interest Received at Sale or
Annually and Maturity and Taxed at Sale Interest Received at Sale or Taxed Annually or Maturity Maturity but Taxed Annually
• Savings accounts
• CDs
• Money market accounts
• Bond interest payments actually received in the year
• Accrued market discount on bonds
• Interest earned on U.S.
savings bonds
• Original issue discount (OID) on corporate and Treasury bonds
Because dividend income is generally taxed at lower rates than interest income, it appears that taxpayers seeking current cash flows from their investments should favor dividend-paying investments over interest-paying investments. This raises the question why anyone would ever prefer investments paying interest over those paying dividends.
Remember, though, that savvy investors also should consider nontax factors, such as before-tax rates of return, risk, and liquidity needs when choosing among investments.
These fundamental differences explain why investors may continue to seek out interest income in spite of the associated tax disadvantages.