Everybody loves making money. But do you know what’s even better than making money? Watching your money make money. That’s basically what interest income is. It’s your reward for saving and investing your hard-earned cash wisely (and it’s much better than paying interest for borrowing money).
But don’t forget that interest income is taxable, and Uncle Sam is going to get his cut sooner or later. So it’s important to know ahead of time how interest income is taxed and how to report that income when you sit down to file your taxes. Let’s get right to it!
What Is Interest Income?
Interest income is money that’s earned inside certain types of bank accounts and investments. It’s basically the way banks and other financial institutions say “thank you” for choosing to do business with them! If you have $1,000 sitting in a savings account with a 1% annual interest rate, for example, that account will earn about $10 in interest income over the course of a year.
Types of Interest Income
You can earn interest income from many different places, but here are some of the main types of interest income you’ll probably come across:
- Interest from checking accounts, savings accounts and money market accounts
- Interest from certificates of deposit (CDs)
- Interest from bonds (such as government bonds, corporate bonds and municipal bonds)
There are definitely other sources you might receive interest income from—like interest from annuities or from lending money to someone—but those are less common.
How Is My Interest Income Taxed?
Most of the time, you’ll report interest income on your federal tax return and that money will be taxed as ordinary income. That means your interest income will be added on top of your other sources of ordinary income to help determine what income tax bracket you’re in, and then it will be taxed according to your income tax rate.
For example, if you earned $1,000 in interest income and you’re in the 22% tax bracket, you’d probably owe around $220 on that interest income ($1,000 x 0.22 = $220).
There are some exceptions, though! Municipal bonds, which allow you to basically loan money to state and local governments, are not taxed at the federal level and are usually free from most state and local taxes. And U.S. Treasury bonds are only taxed at the federal level and not at the state or local level.
How Do I Report Interest Income?
A lot of the time, paying taxes on your interest income can feel a little bit like an Easter egg hunt . . . except you’re scouring your bank’s website for the tax forms you need to file your taxes correctly instead of digging through bushes for eggs filled with miniature Snickers. Sure, it’s not as fun . . . but at least you won’t get in trouble with the IRS. So that’s . . . something.
Truth is, reporting your interest income is as easy as 1-2-3! Here are three steps to help you get there:
Step 1: Collect Your 1099-INT Forms
If you earned interest income from money held at a bank or other financial institution, you should expect to receive a 1099-INT from anyone who paid you that interest.1 This form will show you how much interest you earned throughout the year and what type of interest it was.
Step 2: Fill Out Your Schedule B
Then you’ll gather up all those 1099-INT forms you received and you’ll list everyone who paid you interest plus the amounts you received on Part I of your Schedule B (which is attached to the Form 1040 you use to file your tax return).2 Then you’ll add all that interest up, and that’s how much taxable interest you have for the tax year.
Step 3: Enter the Amount of Taxable Interest on Your Form 1040
Once you have all your taxable interest added up on your Schedule B, you’ll just enter that number on your 1040 Form where it asks for your “taxable interest.”3 And you’re done!
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What’s the Difference Between Interest Income, Capital Gains and Dividends?
It’s important to remember that interest income is taxed differently from capital gains and dividends. Let’s do a quick breakdown of each so we don’t get confused on these different sources of income and how they are taxed by Uncle Sam:
When you buy and sell investments for a profit, you’re dealing with capital gains. It’s that whole “buy low, sell high” idea you hear a lot about in the investing world.
When you sell a mutual fund, stock or other type of investment for more than you bought it for, those are called capital gains. And there are two types of capital gains: long-term capital gains and short-term capital gains. Each type is taxed differently, and it all depends on how long you owned the investment before selling it.
- Long-term capital gains. When you hold an asset for a year or more before selling it, those are long-term capital gains. These capital gains are taxed at the capital gains rate—which is 0%, 15% or 20%, depending on what your income is.
- Short-term capital gains. If you bought and sold an investment in less than a year, that’s a short-term capital gain. These gains are treated as ordinary income, so you’ll be taxed according to your ordinary income tax rate.
If you own mutual funds or stocks, a company or brokerage firm might pay out a cash reward to you and other shareholders from time to time as a pat on the back for doing business with them. Those payments are called dividends, and how they’re taxed depends on whether they are qualified dividends or unqualified dividends.
- Qualified dividends are the most common, and they are taxed at the long-term capital gains rate—which is lower than ordinary income tax rates.
- Unqualified dividends, on the other hand, are not eligible for that more favorable tax rate and are taxed as ordinary income.
What About Interest Income From Retirement Accounts?
If you’re socking away money inside a 401(k) at work or an IRA on your own, way to go! Saving money in tax-advantaged retirement accounts is the best way to build a nest egg that will help you enjoy the retirement you’ve always dreamed about.
But how is the interest growth you’ve earned inside a retirement account taxed? Here are a couple things you need to know.
First, you’ll pay taxes on all the money (including any interest earned) inside a tax-deferred retirement account like a traditional 401(k) or traditional IRA whenever you decide to take the money out. You’re basically kicking the tax bill down the road . . . taking a tax deduction now, but paying up later. And those withdrawals will be taxed as ordinary income, just like most of the other types of interest income we’ve talked about.
Second, when you put money inside a tax-free retirement account like a Roth IRA, you won’t have to pay taxes on any of the money you take out of the account in retirement—that includes any interest earned over the years! That’s because you pay your taxes on that money before it goes into the Roth IRA.
That’s why we recommend investing in Roth accounts like a Roth IRA or a Roth 401(k) whenever those options are available to you. Because the last thing you want to be thinking about when you’re drinking piña coladas on a beach somewhere in retirement is taxes!
Work With a Financial Advisor
The best way to make sense of interest income, investments and how to make it all work for you is to work with a financial advisor who can break things down in a way that is easy to understand. Our SmartVestor program can help you find a financial advisor who can sit down with you and give you a plan for your money!
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This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.