Do You Have to Pay Taxes on Interest?

Interest income represents the earnings an individual receives from deposited funds or loans. This financial gain arises when money is held in accounts such as savings accounts or Certificates of Deposit (CDs), or when it is lent to others through various investment vehicles. Understanding how this income is treated for tax purposes is an important aspect of personal financial management, as tax regulations directly influence the net amount of interest received.

General Taxability of Interest

Interest income is generally subject to federal income tax, treated as ordinary income. This principle applies unless a specific legal exemption or exclusion exists. Therefore, any interest earned from sources available for withdrawal without penalty is usually considered taxable in the year it becomes available.

The tax rate applied to interest income is typically the same as an individual’s marginal federal income tax rate. These rates can vary depending on overall income levels and filing status. While federal income tax is commonly applied, interest income may also be subject to state and local income taxes, depending on the specific type of interest and the taxpayer’s state of residence. All taxable interest income must be reported on a federal tax return, even if the amount is small.

Common Sources of Taxable Interest

Many common financial products generate interest income that is generally subject to federal income tax. These include interest earned from funds held in savings accounts, checking accounts, and money market accounts. Certificates of Deposit (CDs) also yield taxable interest.

Corporate bonds represent another typical source of taxable interest. The interest paid on these bonds is almost always subject to federal income tax. Additionally, interest received on income tax refunds is considered taxable income. Even interest from personal loans made to others, such as peer-to-peer lending, is generally taxable and must be reported by the lender.

Non-Taxable and Partially Taxable Interest

While most interest is taxable, certain types of interest income are either fully or partially exempt from federal, state, or local income taxes. Interest earned from municipal bonds, which are issued by state or local governments to fund public projects, is generally exempt from federal income tax. If a municipal bond is issued by a government within the taxpayer’s state of residence, the interest is often also exempt from state and local income taxes, leading to what is sometimes called “triple-exempt” interest.

Another type of interest that may be non-taxable under specific conditions is the interest from certain U.S. savings bonds. Interest from Series EE and Series I U.S. savings bonds issued after 1989 can be excluded from income if the bond proceeds are used to pay for qualified higher education expenses in the same year. This exclusion is subject to specific income limitations.

U.S. Treasury bonds, notes, and bills represent a form of partially taxable interest. The interest income from these federal government securities is subject to federal income tax. However, a significant advantage of U.S. Treasury securities is that their interest income is exempt from state and local income taxes. This distinction can offer considerable tax savings for individuals residing in states with high income tax rates.

Reporting Interest Income

Financial institutions and other entities that pay interest income are generally required to report these payments to both the IRS and the taxpayer. If an individual receives $10 or more in interest during the tax year, the payer typically issues Form 1099-INT, “Interest Income,” or Form 1099-OID, “Original Issue Discount,” by January 31 of the following year. These forms detail the amount and type of interest earned, including any tax-exempt interest or federal tax withheld.

Even if an individual does not receive a Form 1099-INT because the interest earned is less than $10, all taxable interest income must still be reported on their federal tax return. Taxable interest income is generally reported on Schedule B (Interest and Ordinary Dividends) of Form 1040 if the total taxable interest exceeds $1,500. Tax-exempt interest, while not federally taxed, must also be reported on the tax return, typically on Schedule B, for informational purposes.