These surprise sources of income could cost you during tax season

Published Wed, Feb 28 20242:40 PM ESTUpdated Wed, Feb 28 20243:11 PM EST

Investors are celebrating a year of easy-to-obtain interest income, but the Tax Man will want his slice this spring. Following the Federal Reserve's interest rate hikes, which has left the fed funds rate at its current target range of 5.25% to 5.5%, banks that were once stingy on annual percentage yields are now paying up a little more. That means that while the current national average savings yield is 0.59%, according to Bankrate.com, plenty of institutions are paying upward of 4%. "In 2022, when rates started to come up, we saw more interest than we did in 2021, but the difference between 2022 and 2023 is pretty large," said Elizabeth Buffardi, a certified financial planner and certified public accountant at Crescendo Financial Planners in Oak Brook, Illinois. Institutions report interest income of $10 or more to their customers and the IRS on Form 1099-INT . "So many times, you never got a 1099 from your bank because the interest was like five cents, but now it's not and that's something everyone has to keep an eye on," Buffardi said. There are penalties that apply when you underpay your taxes, which can happen if you don't report all the income you received or if you claim tax breaks for which you don't qualify. For instance, you can be on the hook for an accuracy-related penalty of 20% of the underpayment of the tax. The IRS also charges interest on your penalties until the balance is paid in full. The tax season deadline is April 15. While you can go on an extension to file your return by Oct. 15, you'll still need to pay any sums owed by April 15. Blind spots for investors Unexpected income that can trip up investors can come from municipal bonds they purchased at a sharp discount versus the bond's par value — that is, the amount the issuer will repay the investor at maturity. If the discount on the muni bond is less than 0.25% of the par value, multiplied by the number of years remaining to maturity, then the discount is treated as a capital gain and could be taxed at 0%, 15% or 20%, based on your taxable income. However, if the discount is equal to or greater than 0.25% of par value, times the number of years until maturity, then it's subject to ordinary income taxes. Those levies can be as high as 37%. If you wind up facing taxes on your discounted muni bond, you can either pay some of the amount owed each year or handle it in one payment at maturity. "People buy these bonds and think they just get the tax-free interest payments, but sometimes they end up with ordinary income — and that baffles people," said Jerrod Pearce, CFP, CPA and partner at Creative Planning in Overland Park, Kansas. In another case of income bonanzas biting investors, I bonds, the government issues that investors snapped up in 2022 when they were yielding a record 9.62% in interest, are leaving investors with a tax liability if they've since cashed them in. Interest income from these I bonds is subject to federal income tax, but investors don't receive it until they redeem the bond or it matures. Once they cash in or the bond matures, investors are supposed to get a Form 1099-INT, which you can find on your TreasuryDirect account if that's where you're holding your I-bond. This can trip people up. "The government isn't sending you the documents," said Adam Markowitz, an enrolled agent at Luminary Tax Advisors in Windermere, Florida. "You have to go online to get it — and there will be a lot of notices [from the IRS] when people don't pick up that income." When location matters Here's another situation in which the IRS can take its share of your yields: Investors who hold master limited partnerships — which include oil and gas pipeline companies and can pay dividend yields upward of 7% — enjoy the prospect of greater income. "It's a great constant source of income if you have retirees looking for an income stream," said Brian Kearns, CFP and CPA at Haddam Road Advisors in Evanston, Illinois. "But if you put it in the IRA, there can be a surprise." That's because an MLP in an IRA can cue a tax liability, known as unrelated business taxable income, and the retirement account itself will have to file a tax return. As a result, these partnerships would be better off held in a taxable account. "It might be worth it to buy the MLP and pay the tax," Kearns said. "Like with everything else, it's all about after-tax income."