Knowing how interest is taxed can help you understand how much of your cash goes into your wallet and how much is going to Uncle Sam. What is interest income?Interest income is money earned from investments—like corporate and municipal bonds—bank accounts, like checking and savings accounts, and more. These accounts and investments may earn interest income or ordinary dividends and are, therefore, subject to federal tax:Checking accountsSaving accountsCertificates of deposit (CDs)Money market accountsTreasury bills, notes, and bonds (these are taxed on the federal level but exempt from state and local taxes)Share accountsU.S. savings bondsMutual fundsExchange-traded funds (ETFs)Corporate bondsHow is interest income taxed?Interest income and ordinary dividends (qualified dividends are taxed at capital gains rates) are taxed at the same rate as your ordinary income tax. For example, if your federal income tax rate is 22%, your interest income or dividends will also be taxed at 22%. “Interest income, unlike long-term capital gains, is subject to taxation at taxation at ordinary income tax rates at both the federal and state levels,” says Will Brennan, certified financial planner and founder at Park Hill Financial Planning and Investment Management.Unless your account is tax-advantaged—like an individual retirement account (IRA) or 401(k)—you’ll have to pay federal tax on interest income.And if you’re a high-income earner who receives interest, you may also be subject to an additional tax, the net investment income tax, which is a 3.8% tax on interest, dividends, capital gains, and more. These are the 2023 income thresholds for net investment income tax:Single-filers or head of household: $200,000Qualifying widow(er) with a child: $250,000Married couples filing jointly: $250,000Married couples filing separately: $125,000How do I report interest income?Before tax day arrives, brokerages, banks, and financial institutions will send you a 1099-INT (for interest) or 1099-DIV (for dividends), which displays how much interest you’ve earned in the past year. Brokerages only send this form to taxpayers who earn more than $10 worth of interest. Even if your financial institution doesn’t send you a 1099-INT form because you earn less than $10 worth of interest, you’ll have to report that income because it’s still taxable. Taxpayers earning more than $1,500 in interest or ordinary dividends must also fill out Schedule B (Form 1040). What accounts and investments aren’t subject to tax on interest income?Though it’s impossible to avoid paying taxes on interest income, some taxpayers might consider investing more money in tax-advantaged accounts—like 529 plans, health savings accounts, IRAs, and 401(k)s—to minimize their tax burden in other ways. “Unfortunately, with interest income, there isn’t a good way to avoid income taxes on it because it’s treated as ordinary income,” says Brennan. “You can make either 401(k) or IRA contributions. That would be a way to reduce your taxable income.”While these accounts offer various tax benefits, there are usually restrictions on how money in these accounts can be used. For example, if you withdraw money from an individual retirement account before the age of 59 ½, you could have to pay a 10% penalty tax in addition to any federal and local taxes.There are, however, some investments you won’t have to pay federal interest income tax on, like municipal bonds—or debt that’s issued by state governments. Depending on if you’re a resident of the state where you purchased the municipal bond, you may be exempt from state income tax, too. “If you were a Connecticut resident that had investments in municipal bonds from Kansas or Ohio or Texas, the interest earned would be exempt [from] federal [taxes] but taxable by the state,” says Jim Arcouette, a CPA and partner at Fiondella, Milone & LaSaracina LLP. “If you had bonds that were from Connecticut and were a Connecticut resident, it would be both exempt at the federal level and at the state level.”Though municipal bonds are exempt from federal tax, you are still required to report any interest you earn on these investments to the IRS.The takeaway Whether you’re putting aside cash in a CD to save up for a down payment or investing in treasury notes because yields are high, you should prepare to pay taxes on the interest you earn. Though you can’t avoid paying taxes on earned interest or dividends, taking advantage of tax-sheltered investment accounts like a Roth IRA can help you save some money.If you do earn interest on your investments, your brokerages will send forms if you earn more than $10 worth of interest and dividends. Make sure to report all your earned interest and dividends. Otherwise, the IRS may require you to pay up with penalties.
