What Is the Tax Rate on Interest Income?

Interest income is a common aspect of personal finance, and understanding its tax implications is important. When you earn interest from various sources, it generally counts as taxable income that must be reported to the Internal Revenue Service (IRS). This income can arise from different types of accounts and investments, influencing its tax treatment. This guide clarifies what interest income is, how it is taxed, and the steps involved in reporting it.

Understanding Taxable Interest Income

Interest income refers to money earned from lending funds or depositing them in interest-bearing accounts. Most of these earnings are considered taxable by the federal government. Common examples include interest from savings accounts, certificates of deposit (CDs), and money market accounts. Interest accrued on these accounts, even if reinvested, is taxable in the year it is earned or made available for withdrawal.

Corporate bonds generate taxable interest income at both federal and state levels. These debt instruments provide investors with regular interest payments. Similarly, interest from seller-financed mortgages is generally taxable income to the recipient.

Some interest income receives preferential tax treatment. Interest from U.S. Treasury bonds, bills, and notes is taxable at the federal level but exempt from state and local income taxes. This offers a tax advantage, especially for those in states with high income taxes.

Municipal bonds, issued by state and local governments, are generally exempt from federal income tax. If you reside in the state where the bond was issued, the interest may also be exempt from state and local taxes. Not all municipal bonds qualify for these benefits; private activity bonds, which fund private projects, may be subject to the Alternative Minimum Tax (AMT).

How Interest Income is Taxed

Taxable interest income is treated as “ordinary income” for federal tax purposes. This means it is taxed at your regular marginal income tax rate, similar to wages or salary earnings. It is added to your other income to determine your total taxable income.

A marginal tax rate is the tax rate applied to your last dollar of income. The U.S. tax system is progressive, meaning different portions of your income may be taxed at different rates. For example, if you are in the 24% tax bracket, lower portions are taxed at 10%, 12%, and 22%.

Interest income contributes to your Adjusted Gross Income (AGI). An increase in AGI due to interest income can affect your eligibility for certain tax deductions, credits, or other income-based limitations. For high-income earners, interest income may also be subject to the Net Investment Income Tax (NIIT), an additional 3.8% tax on certain investment income.

Reporting Interest Income

Financial institutions are required to report interest income to both you and the IRS. If you earn $10 or more in interest, the institution will send you Form 1099-INT, “Interest Income,” by January 31st of the following year. This form details the interest you earned.

Form 1099-INT includes:
Box 1 shows total taxable interest income received.
Box 2 reports early withdrawal penalties, which may be deductible.
Box 3 reports interest on U.S. savings bonds and Treasury obligations.
Box 8 is used for tax-exempt interest, such as from municipal bonds.

You must report all taxable interest income on your federal income tax return, even without a Form 1099-INT. If your total taxable interest income from all sources exceeds $1,500, you will need to file Schedule B, “Interest and Ordinary Dividends,” with your Form 1040. On Schedule B, you list the names of the payers and the amounts of interest received. The total taxable interest from Schedule B is then transferred to your main Form 1040. Tax-exempt interest is also reported on Form 1040, typically on a separate line.