What Is Taxable Interest Income? And How to Report It

Interest income represents money earned from various sources for lending funds or holding deposits. Its tax treatment varies depending on the source. Understanding these distinctions is important for accurate tax reporting. Not all interest income is subject to federal, state, or local taxes in the same manner.

Identifying Taxable Interest Income

Most interest income received by individuals is subject to federal income tax, treated as ordinary income. This means it is taxed at the same rates as wages or salaries. Common sources of taxable interest include funds held in savings accounts, checking accounts, money market accounts, and Certificates of Deposit (CDs). Interest from corporate bonds is another typical source of taxable income. When an individual lends money to others, such as through a personal loan, any interest received on that loan is considered taxable income. Similarly, interest earned from installment sale payments, where a buyer pays for property over time with interest, is also fully taxable.

Interest income derived from U.S. Treasury bonds, notes, and bills is subject to federal income tax. However, a notable exception for these instruments is their exemption from state and local income taxes.

Interest Income Not Subject to Tax

While most interest is taxable, certain types are exempt from federal income tax, and sometimes from state and local taxes. Interest earned from municipal bonds, which are debt securities issued by state and local governments, is generally exempt from federal income tax. If the municipal bond is issued by a government within the taxpayer’s state of residence, the interest may also be exempt from state and local taxes.

Another type of interest that can be tax-exempt under specific conditions is from qualified U.S. savings bonds, such as Series EE and Series I bonds. The interest from these bonds may be excluded from federal income tax if the bond proceeds are used to pay for qualified higher education expenses in the year the bonds are redeemed. This exclusion is subject to income limitations and other requirements. Additionally, interest received on certain federal income tax refunds is generally not subject to taxation.

Reporting Interest Income for Tax Purposes

Financial institutions and other payers are generally required to report interest income to both the taxpayer and the Internal Revenue Service (IRS). Taxpayers typically receive Form 1099-INT, “Interest Income,” by January 31st each year if they earned $10 or more in interest. This form details the amount of interest paid, any early withdrawal penalties, and federal income tax withheld.

To report interest income, taxpayers usually transfer the information from Form 1099-INT to their federal income tax return, typically on Schedule B (Form 1040), “Interest and Ordinary Dividends.” Even if the total interest income is less than $1,500, or if a Form 1099-INT is not received (for instance, for amounts under $10), all taxable interest income must still be reported to the IRS.

Specific Situations for Interest Income

Certain less common scenarios also affect how interest income is treated for tax purposes. Original Issue Discount (OID) occurs when a bond or other debt instrument is issued at a price lower than its face value. This discount is considered interest and is generally taxable to the bondholder over the life of the bond, even if no cash interest payments are received until maturity. This income is typically reported on Form 1099-OID.

When bonds are bought or sold between interest payment dates, the buyer often pays the seller for interest that has accrued since the last payment. This “accrued interest” is taxable to the seller, not the buyer. The buyer will receive a Form 1099-INT that includes this accrued interest, but they can deduct it from their total interest income on Schedule B to avoid being taxed on interest they effectively paid.

If a bond is purchased at a premium, meaning for more than its face value, the taxpayer may elect to amortize this bond premium over the life of the bond. Amortizing the premium reduces the amount of taxable interest income reported each year. For taxable bonds, this election is optional, but for tax-exempt bonds, amortization is generally required.

Interest earned from foreign sources, such as foreign bank accounts or investments, is generally taxable in the United States, as U.S. taxpayers are taxed on their worldwide income. Specific reporting requirements may apply depending on the value of the foreign assets.