Chapter 7: Portfolio Income—Interest and Dividends

Portfolio income

Income from investments, such as interest and dividends. Example: Interest from a CD and dividends from stock are portfolio income.

Debt holder

An investor who lends money to a bank, government, or corporation and is entitled to interest payments and repayment of principal. Example: Buying a corporate bond makes you a debt holder.

Equity holder (shareholder)

An investor who owns stock in a corporation. Shareholders may receive dividends if declared but are not legally guaranteed dividends or return of their investment. Example: Buying Coca-Cola stock makes you an equity holder.

Why is debt generally less risky than equity?

Debt holders have legal rights to interest and repayment of principal; shareholders do not have a guaranteed dividend or return of investment. Example: A bondholder has a contractual claim, while a stockholder's return depends on the company.

Interest income tax rate

Interest income is generally taxed at ordinary income tax rates. Example: $1,000 of bank interest is taxed at the taxpayer's ordinary rate.

Dividend income tax rate

Dividends are taxed annually; qualified dividends generally receive lower capital-gain tax rates, while nonqualified dividends are taxed at ordinary rates. Example: A qualified dividend may be taxed at 15% instead of a 32% ordinary rate.

General timing rule for interest

Taxpayers generally recognize interest income when they receive the interest payment. Example: Interest paid by a savings account during the year is included in that year's income.

Savings account interest

Interest credited or paid by a savings account is generally taxable annually at ordinary rates. Example: $250 of interest credited during the year is taxable this year.

Money market account interest

Interest from a money market account is generally taxable annually when received. Example: $400 of annual money market interest is current ordinary income.

Certificate of deposit (CD)

An interest-paying investment; interest is generally taxable annually when received or credited. Example: A CD pays $600 of interest this year, so $600 is included in gross income.

Bond maturity value (face value)

The principal amount paid to the bondholder at maturity. Example: A bond with a $10,000 face value pays $10,000 when it matures.

Coupon rate

The stated interest rate on a bond that pays periodic interest. Example: A $10,000 bond with a 6% coupon rate pays $600 of annual interest, subject to its payment schedule.

Zero-coupon bond

A bond that does not make periodic interest payments; its return is generally received at maturity. Example: A zero-coupon bond can create taxable OID income even though no cash is received during the year.

Corporate bond interest

Corporate bond interest is taxable federally and generally taxable by states. Example: Interest paid by an AMD corporate bond is ordinary income and is not state-tax exempt.

U.S. Treasury bond or note interest

Interest paid by U.S. Treasury bonds and notes is taxable federally but exempt from state income tax. Example: A taxpayer includes Treasury interest on the federal return but not on the state return.

Original issue discount (OID)

The discount when a bond is originally issued for less than its maturity value. Taxpayers amortize the discount and include the annual amount in gross income. Example: A zero-coupon bond issued for $9,000 and payable at $10,000 produces OID income over its life.

OID tax timing

OID is taxed annually even if the taxpayer receives no cash interest payment. Example: A zero-coupon bondholder reports $4,080 of OID this year although no payment was received.

Form 1099-OID

The information form used by a bond issuer or broker to report a taxpayer's annual OID amortization. Example: The investor uses the OID shown on Form 1099-OID when reporting interest income.

Bond issued at a premium

A bond issued for more than its maturity value. A taxpayer may elect to amortize the premium to offset interest income. Example: Paying $10,500 for a bond that will repay $10,000 creates a $500 premium.

Bond premium amortization

An optional annual deduction-like offset against taxable interest for a bond bought at a premium; it also reduces the bond's tax basis. Example: $300 of annual premium amortization reduces $1,200 cash interest to $900 taxable interest.

Tax basis of a premium bond

The original basis includes the premium and is reduced by premium amortization over the bond's life. Example: A $10,500 basis is reduced as the $500 premium is amortized.

Secondary market bond

A bond purchased from another investor after it was originally issued. Example: Buying an existing bond through a broker is a secondary-market purchase.

Market discount

A discount created when a taxpayer purchases a bond in the secondary market for less than its maturity value. It is generally treated as interest income at sale or maturity. Example: Buying a $10,000 maturity bond for $9,200 creates $800 of market discount.

Accrued market discount

The ratable part of market discount recognized as interest income when a bond purchased at a discount is sold before maturity. Example: If part of the $800 discount has accrued by sale, that portion is ordinary interest income.

Market discount at maturity

If a secondary-market discount bond is held to maturity, the entire market discount is treated as interest income at maturity. Example: A $24,000 discount is reported as interest when the bond matures.

Market premium

The amount paid above a bond's maturity value when buying it in the secondary market. It may be amortized to reduce annual interest income. Example: Paying $10,300 for a $10,000 maturity bond creates a $300 market premium.

U.S. savings bond (Series EE or I)

A U.S. bond issued at face value or a discount that does not pay periodic interest; interest accumulates until redemption. Example: A Series EE bond's value grows until it is cashed in.

Savings bond interest timing

Interest on Series EE and Series I savings bonds is generally recognized when the bonds are redeemed at maturity or earlier. Example: A bond bought for $500 and redeemed for $700 produces $200 of interest income at redemption.

Savings bond annual-inclusion election

A taxpayer may elect to include the yearly increase in redemption value as income, but it usually accelerates tax without cash to pay it. Example: Reporting $100 of annual growth before redemption is usually not ideal.

Savings bond education exclusion

Interest from Series EE and Series I bonds may be excluded to the extent proceeds pay qualifying education expenses, subject to modified-AGI phaseouts. Example: Eligible bond proceeds used for tuition can reduce taxable savings-bond interest.

Qualified dividend

A dividend eligible for preferential tax rates (0%, 15%, or 20%) if it is paid by a domestic or qualified foreign corporation and the holding-period rule is met. Example: A qualifying dividend from stock held long enough may be taxed at 15%.

Qualified dividend holding-period rule

The stock must be held more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Example: Holding the stock only 30 days does not meet the rule.

Ex-dividend date

The first day a purchaser of stock is not entitled to receive a declared dividend. It is used to determine the 121-day qualified-dividend holding period. Example: The 121-day window starts 60 days before this date.

Nonqualified dividend

A dividend that does not meet the requirements for preferential rates and is taxed at ordinary income tax rates. Example: A dividend on stock not held long enough is nonqualified.

Form 1099-DIV

The form corporations send after year-end reporting dividend amounts and whether they are potentially eligible for preferential treatment. Example: A shareholder uses Form 1099-DIV to report dividends but must still confirm the holding period.

Reinvested dividend

A dividend automatically used to buy more shares instead of being paid in cash; it is still taxable annually. Example: A $200 dividend reinvested in mutual-fund shares is still $200 of dividend income.

Interest versus dividends investment choice

Taxes are only one factor; investors should also consider before-tax return, risk, and liquidity needs. Example: A taxpayer may choose Treasury interest for safety even if qualified dividends receive a lower tax rate.

Example: Courtney's dividend income

Courtney invests $50,000 in Xerox stock and $50,000 in Coca-Cola stock, each yielding 8%. Her annual dividend income is $4,000 + $4,000 = $8,000.

Example: qualified vs. nonqualified dividend tax

With $8,000 of dividends, a 32% ordinary rate produces $2,560 tax if nonqualified; a 15% qualified-dividend rate produces $1,200 tax if qualified.

Example: Series EE vs. original-issue zero-coupon bond

In year 1, Series EE bond interest is generally $0 until redemption, while original-issue zero-coupon bonds require annual OID income. Example: Courtney reports $0 for Series EE but $4,080 OID for AMD bonds.

Example: secondary-market zero-coupon bond

A zero-coupon bond bought after original issue at a $24,000 market discount produces $0 interest in year 1 and $24,000 of interest at maturity if held to maturity.