Interest usually comes from banks, investment accounts, or bonds and is generally pretty straightforward. You receive a Form 1099-INT and you report the interest income on your tax return.
Not every investment that pays interest is a no-brainer, though. With a CD, you generally have to include the interest in your income when you actually receive it, which is usually when the CD matures. This can benefit you if you invest in a CD late in the year. For example, if you invest in a 6-month CD in August 2008, the CD won't mature until March 2009 and you won't have to report the interest until you file your 2009 return in the spring of 2010.
Municipal bonds or municipal bond funds pay tax-exempt interest that you need to report, even though it seems like you shouldn't have to. Occasionally your tax-exempt interest becomes not so tax-exempt. When this happens, your investment is classified as a private activity bond, and the interest becomes taxable if you end up paying Alternative Minimum Tax (AMT).
Interest on U.S. Savings Bonds falls into a special category but, in most cases, it's still taxable on your federal return. You don't pay state tax on it, though. If you meet certain qualifications and use the bond proceeds to fund education, the income is tax-free on your federal return. To learn more, see U.S. Savings Bond Interest Exclusion.
Dividends are usually paid by corporations or mutual funds. Many dividends are both "ordinary" and "qualified." Ordinary dividends are nothing new. They are usually paid at regular intervals, such as every quarter, by corporations or a mutual fund.
The concept of qualified dividends has only been around for a few years. Qualified dividends are taxed at a lower rate than other income. The lower rate is either 0% or 15%, depending upon your marginal tax rate.
Your dividends must meet certain requirements to be qualified dividends, but most dividends do:
In general, the dividends must have been paid by a U.S. corporation, although payments from certain foreign corporations can also qualify.
You must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock will not receive the next dividend payment.
The dividends aren't a type that is specifically excluded from qualified dividend income by tax law. This includes dividends from credit unions, savings institutions, ESOP stock, tax-exempt corporation stock, and, occasionally, mutual fund dividends (your mutual fund should tell you if your dividends are qualified or not).
You must pay tax on dividend income in the year that you receive it, even if the money was reinvested in additional shares. Your financial institution will send you a Form 1099-DIV reporting the dividend income that you received. If the income is from a qualified dividend, you'll see the same number reported in 2 places on your Form 1099-DIV, and that's OK.
If your dividend income is from a mutual fund, you might receive a separate statement from your mutual fund company that shows the percentage of dividend income that came from U.S. Treasury securities. This information becomes important when you file your state return because you don't pay state tax on U.S. Treasury securities. As you enter your dividend income in the Interview, make sure to select the -- Some dividends in box 1 are from U.S. Treasury obligations -- box.
Capital gain distributions aren't really dividends -- instead, they are your share of a mutual fund's buying and selling activities. If a mutual fund buys an investment, holds it for more than a year, and then sells it at a profit, you'll see capital gain distributions on your Form 1099-DIV. Like qualified dividends, capital gain distributions are taxed at either 0% or 15%, depending upon your marginal tax rate. To learn more, see Capital Gain Distributions.
If your mutual fund paid foreign income taxes, your mutual fund company will report the amount paid on your Form 1099-DIV. If this is the case, you might be entitled to claim the foreign tax credit. To learn more, see Foreign Tax Credit.
Some corporations or mutual funds have dividend reinvestment plans. This sort of plan lets you use your dividends to buy additional shares of stock instead of paying out the dividends in cash. Even if the dividend isn't paid out in cash, you must still pay tax on it. It’s as if you received the cash and then immediately turned around and purchased more shares.
At a later date, if you sell the shares you purchased through a dividend reinvestment plan, you'll need to figure your capital gain or loss on the sale. To do this, you'll need to calculate the basis of the shares you sold. In this case, your basis would be the amount you paid for the original shares plus the amount you paid for each purchase you made through dividend reinvestment. Because this can be difficult to calculate, you can choose to use the average basis of the mutual fund shares you sold. To learn more, see Average Basis Method.