How Much Tax Do You Pay on Interest?

Interest income represents earnings from lending money or holding interest-bearing assets. This income is generated from sources like savings accounts, certificates of deposit, and certain investments. Like wages or business profits, interest income is generally subject to taxation. Understanding its tax implications is an important aspect of personal financial management. The specific amount of tax owed depends on the type of interest, the taxpayer’s overall income, and applicable tax laws.

Understanding Taxable and Non-Taxable Interest

The taxability of interest income is not uniform; some types are fully taxable, while others are partially or entirely exempt. Different sources of interest are treated distinctly under tax law, which determines whether your interest contributes to taxable income.

Many common sources of interest are fully taxable at the federal level. This includes interest from traditional savings accounts, checking accounts, money market accounts, and certificates of deposit (CDs). Interest from corporate bonds is also fully taxable. Any interest received from loans made to others is generally taxable as well.

Conversely, certain types of interest income are tax-exempt under specific conditions. An example is interest from municipal bonds. These bonds are issued by state and local governments to finance public projects. Interest from municipal bonds is exempt from federal income tax.

If a municipal bond is issued by a government entity within your state of residence, the interest may also be exempt from state and local income taxes in that state. This dual exemption makes municipal bonds an attractive option for certain investors seeking tax advantages.

Another category involves U.S. Treasury bonds, notes, and bills. Interest from these federal obligations is subject to federal income tax. However, U.S. Treasury interest is exempt from state and local income taxes. This exemption can provide a tax benefit for residents of states with higher income tax rates. Understanding these differences in tax treatment based on the source of interest income is fundamental to assessing your overall tax liability.

How Federal Income Tax Applies to Interest

After determining taxability, understanding how federal income tax rules apply to interest earnings is next. Most taxable interest income is treated as “ordinary income.” This means it is subject to the same marginal tax rates that apply to wages, salaries, and other regular income. Interest income contributes to your total taxable income, placing you within a specific federal income tax bracket.

The United States employs a progressive tax system, where different portions of income are taxed at increasing rates, known as marginal tax brackets. When taxable interest income is added to your other ordinary income, it can impact your overall effective tax rate or push a portion of your income into a higher marginal tax bracket. For example, if you earn $1,000 in interest and are in the 22% tax bracket, approximately $220 of that interest would be owed in federal taxes, assuming no other deductions or credits apply.

Financial institutions that pay interest income are required to report these earnings to both the taxpayer and the Internal Revenue Service (IRS). This reporting is done through Form 1099-INT, “Interest Income.” This form is issued if you earned at least $10 in interest during the tax year. Form 1099-INT details the amount of interest paid and any early withdrawal penalties.

Taxable interest income is reported on your federal income tax return, typically on Form 1040. If your total taxable interest income exceeds $1,500, you will need to file Schedule B, “Interest and Ordinary Dividends,” with your Form 1040. Schedule B provides a detailed breakdown of all interest income received from various payers. Even if you do not receive a Form 1099-INT because the interest earned was less than the reporting threshold, all taxable interest income must still be reported on your tax return.

Additional Federal Taxes on Interest

Beyond the standard federal income tax, certain taxpayers may be subject to an additional federal tax on their investment income, including interest. This is known as the Net Investment Income Tax (NIIT), a 3.8% surtax that applies to individuals, estates, and trusts with income exceeding specific thresholds.

Interest income is considered net investment income for the NIIT. If a taxpayer’s modified adjusted gross income (MAGI) surpasses statutory thresholds, a portion of their interest earnings could be subject to this additional 3.8% tax. The NIIT applies to the lesser of a taxpayer’s net investment income or the amount by which their MAGI exceeds the applicable threshold.

The income thresholds for individuals are established based on filing status. For single filers or those filing as Head of Household, the NIIT applies if MAGI exceeds $200,000. For married couples filing jointly or qualifying widow(er)s, the threshold is $250,000. Married individuals filing separately face a threshold of $125,000. This tax is assessed in addition to any regular income tax liability.

For example, if a single filer has a MAGI of $220,000, including $30,000 from interest income, their MAGI exceeds the $200,000 threshold by $20,000. The NIIT would then apply to the lesser of their net investment income ($30,000) or the excess MAGI ($20,000), resulting in a 3.8% tax on $20,000, which is $760. Taxpayers who owe the NIIT must file Form 8960, “Net Investment Income Tax—Individuals, Estates, and Trusts,” with their federal tax return.

State and Local Tax on Interest

The taxation of interest income at the state and local levels introduces another layer of complexity, as rules vary significantly across different jurisdictions. While federal tax laws provide a baseline, states and localities have their own regulations regarding what types of interest income are taxable. Consequently, interest exempt at the federal level might be taxable at the state level, or vice versa, depending on your residence.

Some states may tax all interest income received by their residents, regardless of the source. Other states offer specific exemptions for certain types of interest. A common state-level exemption is for interest from municipal bonds issued within that taxpayer’s state of residence. This means interest from a bond issued by your home state’s government may be exempt from both federal and state income taxes.

A consistent rule across most states is the exemption of interest from U.S. Treasury securities from state and local income taxes. While this interest is subject to federal income tax, states are prohibited from taxing income derived from federal obligations. This makes U.S. Treasury bonds, notes, and bills a potential consideration for residents of states with higher income tax rates.

Given the wide variations in state and local tax laws, it is impractical to provide a comprehensive guide for every jurisdiction. Taxpayers should consult their specific state’s tax department or a qualified local tax professional to understand the precise tax treatment of their interest income. This personalized guidance ensures compliance with local regulations and helps in accurately calculating overall tax obligations.