Do You Have to Pay Tax on Interest Income?

Most interest income is taxable, but exceptions and reporting requirements exist. This article clarifies when interest income is subject to tax and when it is not.

Common Taxable Interest Income

Most interest income is taxable at the federal and typically state levels. This includes interest from traditional savings, checking, and money market accounts. Financial institutions generally pay this interest regularly, and it becomes taxable when credited to your account and available for withdrawal.

Interest from Certificates of Deposit (CDs) is generally taxable. Even if reinvested, it is considered income for tax purposes in the year it accrues or is made available. Interest from corporate bonds, which are debt instruments, is fully taxable at both federal and state levels.

Interest from U.S. Treasury bonds, notes, and bills is subject to federal income tax but exempt from state and local income taxes. Additionally, any interest earned on personal loans to individuals or businesses is considered taxable income and must be reported.

Sources of Tax-Exempt Interest Income

While much interest income is taxable, specific types offer exemptions. Interest from municipal bonds, or “munis,” is generally exempt from federal income tax. These bonds are issued by state, city, and local governments to fund public projects. If you purchase a municipal bond issued by your state or locality of residence, the interest may also be exempt from state and local income taxes.

Another source of tax-exempt interest comes from qualified U.S. savings bonds (Series EE and Series I). Interest can be excluded from federal income tax if used for qualified higher education expenses. To qualify, conditions include the bond owner being 24 years or older when issued, and modified adjusted gross income below IRS thresholds. Qualified expenses include tuition and fees for the taxpayer, their spouse, or a dependent.

Interest from bonds issued by U.S. territories or possessions also typically enjoys federal tax exemption. This includes bonds from Puerto Rico, the U.S. Virgin Islands, and Guam, providing a tax benefit similar to municipal bonds at the federal level.

Reporting Interest Income

Taxpayers are informed of interest income primarily through Form 1099-INT, “Interest Income.” Financial institutions, including banks and brokerage firms, are generally required to issue this form to you and the IRS by January 31st each year. This form details various types of interest received, including taxable, tax-exempt, and any federal tax withheld.

An institution must issue a Form 1099-INT if you earned $10 or more in interest. Even if the interest earned is less than $10 and you do not receive a 1099-INT, you are still responsible for reporting all interest income on your tax return.

All interest income, both taxable and tax-exempt, must be reported on your federal income tax return. Taxable interest is typically reported on Form 1040, Line 2b. If your total taxable interest exceeds $1,500, you must also complete and attach Schedule B (Interest and Ordinary Dividends). Tax-exempt interest, while not subject to federal tax, is reported on Form 1040, Line 2a, for informational purposes.

How Interest Income is Taxed

Interest income that is not specifically exempt is taxed as ordinary income. It is added to your other income sources, such as wages and salaries, and is subject to your marginal federal income tax rate. For example, if you are in the 22% tax bracket, your taxable interest income will generally be taxed at that 22% rate.

Interest income categorized as tax-exempt is generally not subject to federal income tax, but it is still reported for informational purposes. While federal tax rules apply universally, state and local tax implications for interest income can vary. Interest from U.S. Treasury obligations is exempt from state and local income taxes. Municipal bond interest is often exempt from state tax only if the bond was issued by a government entity within your state of residence.