In the United States, there are various types of investments and accounts that may generate interest income on deposited funds. Interest income may arise from government bonds, corporate bonds, or private loans. The interest is received annually or at other intervals and is classified by the Internal Revenue Service (IRS) as ordinary income.
This article reviews how interest income is defined and taxed under U.S. law, including the impact of the tax treaty between the United States and Israel on the taxation of interest income earned by U.S. and foreign investors
Tax on Interest Income in the United States
When it comes to interest income, the IRS focuses on funds accrued through bank accounts, bonds, and other interest-bearing sources.
With respect to bank accounts, interest accrued in savings accounts, checking accounts, or deposits is generally treated as taxable income by the IRS. In addition, interest income is considered ordinary income. This means it is taxed according to the regular federal income tax brackets, which range approximately from 10% to 37%.
Interest income earned by nonresidents from U.S. sources is generally treated as fixed, determinable, annual, or periodical income (FDAP), which is subject to a flat 30% withholding tax rate unless an applicable tax treaty reduces that rate.
The tax treaty between the United States and Israel may reduce this rate for Israeli residents who earn interest income from sources in the United States.
Portfolio Interest Exemption
In certain cases, a full exemption may apply to interest income under what is known in the United States as the Portfolio Interest Exemption.
This exemption applies only if certain conditions are met. For example, the recipient of the interest may not be a shareholder holding 10% or more of the borrower. In addition, the debt must be issued in the form of a registered debt instrument bearing stated interest. A debt instrument will be considered registered if it is recorded by the issuer or by an agent on its behalf, or if it is recorded in a formal system under which only the interest may be transferred and which tracks the beneficial owner of the interest.
It is also important to note that this exemption is intended to encourage foreign investment in the United States, and therefore applies only to nonresidents and not to U.S. citizens.
Interest on Bonds and Other Taxable Sources
Interest accrued on U.S. Treasury bills and bonds, corporate bonds, and many other debt instruments is generally taxable as ordinary income, at the regular federal income tax rate applicable to the holder. As a rule, the tax treatment does not depend on whether the investment was sold, but rather on the receipt of the interest payments as income.
Other types of taxable interest may also arise outside a bank account or brokerage account, including interest on private loans, U.S. savings bonds, certain insurance proceeds, or interest paid by the IRS. Unless a specific exemption applies, these types of interest are also generally treated as ordinary income.
A taxpayer may receive Form 1099-INT only if the amount meets the relevant reporting threshold, which is generally $10, but interest income may still be taxable even if such a form was not issued.
Reporting Interest Income from Investments
Type of Income | Reporting | Form | Tax Considerations |
Bank interest | 1099-INT | Form 1040 | If total interest income exceeds $1,500, Schedule B must also be completed. |
Interest on U.S. Treasury securities and savings bonds | 1099-INT | Form 1099 | |
Other interest income | 1099-INT | Form 1040 | Interest paid by the IRS is taxable, even when it relates to tax refunds. |
Nonresident
For nonresident, the taxation of interest income works somewhat differently.
First, interest is treated as fixed, determinable, annual, or periodical income (FDAP). This type of income is generally taxed at a rate of 30%, or at a reduced rate under an applicable tax treaty. In addition, nonresidents are exempt from tax on bank deposit interest. Nonresidents may also benefit from the Portfolio Interest Exemption mentioned above if they satisfy its conditions. All other types of interest income are subject to tax at a rate of 30%.
In terms of forms, nonresidents are required to complete several forms, including Form W-8BEN, Form 1042-S, and Form 1040-NR.
The Tax Treaty Between the United States and Israel
In 1975, the treaty between the Government of the United States of America and the Government of Israel with respect to taxes on income was signed. This treaty is intended to prevent double taxation and allow for reduced withholding tax rates, and in some cases even a zero rate.
Article 11 of the tax treaty between the United States and Israel addresses interest income and generally provides for a reduced withholding tax rate of 17.5%. If the interest arises from a loan granted by a bank, insurance company, or other financial institution, the treaty limits the withholding tax rate to 10%.
It is worth noting that if the Portfolio Interest Exemption applies, the treaty rates are irrelevant. This is because the reduced rates established under the tax treaty are intended only to improve the taxpayer’s position, not worsen it.
Common Mistakes
If you do not submit Form W-8BEN, you will be subject to a 30% tax liability on interest income, even if tax treaties or other relief are available. This usually happens when a U.S. payer withholds tax under domestic law because it did not receive the appropriate documentation. In some cases, even if tax was withheld at a rate of 30%, the withholding may still be excessive. For example, this may occur when the Portfolio Interest Exemption applies and the interest should be fully exempt from tax in the United States.
Another common mistake is to treat all bank interest as taxable income. In practice, interest on bank deposits may be exempt, while interest on bonds may be taxable, depending on the circumstances. If exempt interest is mistakenly reported as taxable interest, tax may be collected unnecessarily. In that case, it may be possible to file Form 1040-NR to request a refund for the overpayment.
Finally, another common mistake is failing to report U.S.-source income to the local tax authorities. Many countries tax worldwide income, so it is important to report the income in both countries. It is also advisable to keep copies of all W-8 forms that were submitted in case of a future audit.
TaxLink – Our Story
Understanding how interest income is taxed in the United States is extremely important because it directly affects the amount withheld from savings accounts, bonds, or investments. Whether you are a U.S. resident earning interest from bank accounts or bonds, or a nonresident relying on tax treaties such as the tax treaty between the United States and Israel, small reporting mistakes can lead to significant financial consequences.
TaxLink is an accounting firm with a team specializing in both U.S. and Israeli taxation. Our practical experience with the IRS and the Israel Tax Authority, together with a deep understanding of the interaction between the two systems, allows us to build an end-to-end solution tailored to your case.
Most clients who come to us do so because they are required to file in the United States – whether this involves Form 1040, reporting under the Foreign Account Tax Compliance Act (FATCA), Foreign Bank Account Report (FBAR) filings, or U.S. real estate investments. We manage the process as one coordinated cross-border matter, with the goal of reducing errors, minimizing duplication, and helping prevent double taxation, all within the framework of U.S. law, Israeli law, and the tax treaty between Israel and the United States.
FAQ
If I did not receive Form 1099-INT, do I still need to report interest income?
Yes. Even if you did not receive Form 1099-INT, you are still legally required to report all taxable interest income on your tax return.
How can I know whether my interest income qualifies for the Portfolio Interest Exemption?
Portfolio interest must arise from registered debt obligations, and you must not own 10% or more of the issuer. The bond cannot be connected to a trade or business in the United States, and you must submit Form W-8BEN.
Is it possible to be taxed in both the United States and Israel on the same interest income?
Yes, but if you are an Israeli resident, you may be entitled to a reduced tax rate under the tax treaty between the United States and Israel, and you may also be able to claim a foreign tax credit in Israel to prevent double taxation, depending on the specific circumstances.
Does the tax treaty between the United States and Israel reduce the tax rate on interest income?
Yes. The treaty generally reduces the standard 30% withholding tax rate on certain types of U.S.-source interest income to 17.5% or 10%, depending on the specific circumstances.
