In 1913, the first year the federal income tax was implemented, the tax rate was 1 percent of net income, and it applied to less than 1 percent of the population. The reach of the income tax has extended considerably in the past century and is now applied to all kinds of income, unless that income is specifically exempted by law. The interest on most municipal bonds falls into the tax-exempt category, but you still have to reported it.
The Internal Revenue Service considers most interest that is paid to you or credited to an account from which you can withdraw, to be taxable income. This includes interest on your bank savings account, certificates of deposit, money market accounts, corporate bonds and U.S. Treasury securities. It does not include interest paid on bonds issued by a political subdivision of the United States below the federal level, where the proceeds are used to finance government operations. Such bonds are commonly referred to as municipal bonds or tax-exempt bonds.
Any organization that pays you more than $10 in interest in one year should provide you with a Form 109-INT detailing that payment. If the interest is tax-exempt, the organization should report that amount in Box 8. If you did not provide the payer with your Social Security number or other taxpayer identification number, the payer might withhold backup withholding taxes from your interest payments. If so, the amount of any backup withholding is reported in Box 4.
Reporting Tax-Exempt Interest
While the interest you receive from municipal bonds is exempt from federal income taxes, if you are required to file a federal income tax return, you are required to report your tax-exempt interest. For the 2012 tax year, you'll report your taxable interest on Form 1040, Line 8a, then report your tax-exempt income separately on Line 8b. This is for informational purposes only and does not convert your tax-exempt interest to taxable interest.
Other Tax-Exempt Interest
Interest that is paid on investments you hold in certain retirement accounts, such as a Roth or traditional IRA, is not subject to current income taxation, and you do not report this interest when you file your federal income tax return. Qualified withdrawals from a Roth IRA are completely free from federal income taxes, and there is no requirement to report such income. Qualified withdrawals from a traditional IRA are treated as ordinary income rather than interest income. You would report your traditional IRA distributions on Form 1040, Line 15.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.