What Is Interest Income and How Is It Taxed?
Demystify interest income and its tax implications. Learn how to understand your earnings and navigate the reporting process.
Interest income is money earned from lending funds or holding specific types of investments. It serves as a return on capital, rewarding individuals for allowing others to use their money or for investing in debt instruments. Understanding how this income is generated and treated for tax purposes is important for managing personal finances.
Understanding Interest Income
Interest income is the compensation a lender receives from a borrower for the use of money. This payment reflects the cost of borrowing for the borrower and the gain for the lender. It represents a gain from an investment or savings, contributing to an individual’s financial growth.
Interest income falls into two categories: taxable and tax-exempt. Taxable interest is subject to federal income tax, and often state and local taxes, just like other forms of ordinary income. In contrast, tax-exempt interest offers certain tax advantages, meaning it is not subject to federal income tax and, in some cases, state and local taxes.
Common Sources of Interest Income
Individuals can earn interest income from various sources. Savings accounts and checking accounts generate interest on deposited funds. These accounts provide liquidity.
Certificates of Deposit (CDs) offer a fixed interest rate for a predetermined period, providing a more predictable income stream. Bonds, such as corporate bonds or U.S. Treasury bonds, are another significant source; investors lend money to corporations or the federal government in exchange for regular interest payments. Money market accounts, which combine features of savings and checking accounts, also pay interest, usually at a variable rate. Individuals might also earn interest through peer-to-peer lending platforms.
Tax Treatment of Interest Income
Most interest income is subject to federal income tax at ordinary income rates. Interest earned from sources like savings accounts, CDs, and corporate bonds is taxed at the same marginal tax rates as wages or salaries. For instance, if an individual is in the 24% tax bracket, their taxable interest income will be subject to that 24% rate.
An exception to this rule is interest earned from municipal bonds. These bonds are issued by state and local governments to fund public projects, and their interest payments are typically exempt from federal income tax. If the municipal bond is issued by a government entity within the taxpayer’s state of residence, the interest may also be exempt from state and local income taxes. However, not all municipal bonds are tax-exempt, and some may be subject to the Alternative Minimum Tax (AMT) or other specific tax rules.
The concept of “phantom income” applies to investments like zero-coupon bonds. With zero-coupon bonds, interest accrues but is not paid out until maturity. Despite not receiving cash payments, investors are required to report and pay taxes on this accrued interest annually, as if they had actually received the income. This means a tax liability can arise even without a corresponding cash inflow, requiring careful financial planning.
Reporting Interest Income on Your Taxes
Reporting interest income on tax returns is a necessary step for individuals. Financial institutions, including banks and brokerage firms, are generally required to issue Form 1099-INT to individuals who have earned $10 or more in interest during the calendar year. This form details the amount of interest earned, including any tax-exempt interest, and is also sent to the Internal Revenue Service (IRS).
Upon receiving a Form 1099-INT, individuals should use the information provided to accurately report their interest income on their federal tax return, Form 1040. Even if the total interest earned is less than the $10 reporting threshold, and thus no Form 1099-INT is received, all interest income is still considered taxable and must be reported. If an individual’s total taxable interest income exceeds $1,500, or if certain other conditions apply, they must also file Schedule B (Form 1040), Interest and Ordinary Dividends, to provide a detailed breakdown of their interest income sources.