In this video, we walk through 5 REG practice questions demonstrating how to calculate tax-exempt interest excluded from gross income. These questions are from REG content area 4 on the AICPA CPA exam blueprints: Federal Taxation of Individuals.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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How to Calculate Tax-Exempt Interest Excluded From Gross Income
Understanding the different kinds of interest income and discerning which are taxable versus tax-exempt is important for passing the CPA exam. Here’s an overview focusing on the types of interest a taxpayer might encounter, with examples to illustrate which should be included in or excluded from an individual’s gross income.
Taxable Interest
Taxable interest must be included in your gross income, and it encompasses most forms of interest income, such as:
- Bank Accounts: Interest earned from savings accounts, checking accounts, and certificates of deposit (CDs).
- Example: Interest from a savings account at your bank.
- Corporate Bonds: Interest received from bonds issued by corporations is taxable.
- Example: Bonds purchased from a company, like a tech startup or a retail chain.
- Loans: Interest received from lending money to someone else, including peer-to-peer lending platforms.
- Example: Interest income from a personal loan you provided to a friend or through a lending platform.
- Foreign Investments: Interest earned from foreign bank accounts or bonds.
- Example: Interest from a savings account in a foreign country or bonds issued by a foreign government.
Tax-Exempt Interest
Tax-exempt interest does not need to be included in your gross income, although it should be reported on your tax return. Examples include:
- Municipal Bonds: Interest from bonds issued by state or local governments is often exempt from federal income taxes and sometimes from state taxes if you live in the state where the bond was issued.
- Example: A bond issued by the city of Chicago, if you’re a resident of Illinois.
- U.S. Treasury Securities: Interest on U.S. government bonds, notes, and bills is taxable at the federal level but exempt from state and local taxes.
- Example: U.S. Treasury bonds.
- HSA Interest: Interest earned in a Health Savings Account (HSA) grows tax-free and is not included in your gross income if used for qualified medical expenses.
- Example: Interest accrued in an HSA account established for healthcare expenses.
Special Cases
- Savings Bonds for Education: Interest from certain U.S. savings bonds, like Series EE and Series I, may be tax-exempt if you use the funds for educational expenses under specific conditions.
- Example: Using Series EE savings bond interest to pay for college tuition.
- Tax-Advantaged Accounts: Interest earned in accounts like Roth IRAs or 401(k)s is tax-deferred or tax-free, depending on the type of account and withdrawal circumstances.
- Example: Interest earned on investments within a Roth IRA.
- Interest Received from a Tax Refund: This is an interesting and unique case. This type of interest occurs when the IRS or a state tax authority refunds you more than you paid, often because your tax return is processed after a delay, leading the government to owe you interest on the refund amount for the time it held your money beyond the normal processing period.
- Taxable Income: Unlike the principal amount of your tax refund, which is a return of your own money and not subject to income tax, the interest paid on that refund is considered taxable income. This means you must report it on your federal tax return for the year in which you receive it.
Understanding the Distinction
- Taxable interest adds directly to your taxable income, increasing the amount of tax you owe.
- Tax-exempt interest, while not taxable, must still be reported to the IRS. It can affect the taxability of Social Security benefits and eligibility for certain tax credits.
Example:
Alex, a taxpayer, has multiple investments and accounts, generating different types of interest over the tax year. Here’s a breakdown of the interest Alex received:
- Savings Account Interest: $500 from a traditional bank savings account.
- Corporate Bond Interest: $1,000 from bonds issued by various corporations.
- Municipal Bond Interest: $300 from bonds issued by Alex’s resident state.
- Interest on U.S. Treasury Bonds: $200.
- Tax Refund Interest: $50 received from the IRS due to a delayed tax refund.
- HSA Account Interest: $100 earned on the balance in a Health Savings Account.
- Interest from a Roth IRA: $400, accumulated within the Roth IRA.
Determining Taxable vs. Tax-Exempt Interest
- Included in Gross Income (Taxable):
- Savings Account Interest: $500 is taxable at both federal and state levels.
- Corporate Bond Interest: $1,000 is taxable at federal and possibly state levels, depending on the state’s taxation policies.
- Tax Refund Interest: $50 is taxable at the federal level, as it is considered income received from the government beyond the original tax payment.
- Excluded from Gross Income (Tax-Exempt or Not Reportable as Income):
- Municipal Bond Interest: $300 is exempt from federal taxes and possibly state taxes since the bonds are issued by Alex’s resident state.
- *Interest on U.S. Treasury Bonds: $200 is taxable at the federal level but exempt from state and local income taxes, impacting the gross income reported for state tax purposes but not for federal.
- HSA Account Interest: $100 is not taxable as long as the funds are used for qualified medical expenses. It’s tax-exempt and doesn’t need to be included in gross income.
- Interest from a Roth IRA: $400 is not taxable and not included in gross income, as Roth IRA earnings are tax-free if withdrawals are made according to IRS rules.
