Interest income from your investments is taxable - here's how to calculate what you owe and ways to lower it

• Most interest income earned by investments is taxable on both the federal and state levels.
• You pay taxes on interest income at your ordinary income tax rate.
• You can avoid or defer taxes on interest earned in tax-advantaged accounts and by certain assets.

Paying income taxes is a fact of life. And when the IRS says income, it means all the money you make - both earned, from your work, and unearned, from your investments. That includes interest income - money generated by bank or brokerage accounts, and from certain assets, like bonds or mutual funds.

A few exceptions aside, most investment interest is taxable income. You're required to report it on your return and give the government a cut of it.

So it helps to know a little more about how interest income impacts your tax bill.

What is interest income?

Most types of interest income are subject to both federal and state taxes. This includes the interest you earn on or from:

• US Savings and Treasury bonds
• Corporate bonds
• Mutual funds/ETFs
• Certificates of Deposit (CDs)
• Checking and savings accounts
• Money market accounts
• Loans made to others
• Interest income from pass-through businesses, such as partnerships or S-corporations

Is any interest income tax-free?

Only one major type of asset generates non-taxable interest income: municipal bonds ("munis" for short) and private activity bonds. These are issued by states, counties, cities, and other government agencies to fund major capital projects, such as building public hospitals and schools, highways, power plants, and other civic buildings.

All munis, along with municipal bond funds, are exempt from federal taxes. If the bond is issued by your home state, the interest income it provides is also free from state and local income taxes.

Fast fact: Municipal bonds free of federal, state, and local taxes are dubbed "triple-tax-exempt" bonds.

You also get a bit of a break on US Treasuries and savings bonds. You pay federal income tax on them, but they're exempt from state and local income taxes.

What's the tax rate on interest income?

Interest income doesn't have a special tax rate the way profits on your investments, aka long-term capital gains, do. You pay taxes on the interest as if it were ordinary income - that is, at the same rate as your other income, such as wages or self-employment earnings.

So, if you're in the 24% tax bracket, you'll also pay a 24% rate on your interest income.

For the 2020 and 2021 tax years, there are seven tax brackets:

2020 Tax Brackets (tax returns filed in 2021)

2021 Tax Brackets (tax returns filed in 2022)

Interest income can also be subject to another tax called the Net Investment Income Tax (NIIT). The NIIT is a 3.8% tax on the lesser of:

• Your net investment income, which is generally all of your investment income (including interest, dividends, capital gains, distributions from annuities, income from passive activities, rents, and royalties) minus investment expenses, or
• The amount of your modified adjusted gross income that exceeds $200,000 for singles/heads of household, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately.

How do I report interest income on my tax return?

Around January 31 of each year, you should receive Form 1099-INT from any bank, brokerage firm, or other sources of interest income showing the interest your investments earned in the prior year.

In most cases, it's easy to take the numbers from Form 1099-INT and transfer them to the appropriate place on your tax preparation software or tax return. The figures to focus on are in boxes 1, 3, and 8.

Boxes 1 and 3 of Form 1099-INT show regular taxable interest income and taxable interest from US Savings Bonds and Treasury Bonds. Box 8 shows tax-exempt interest.

Other boxes on Form 1099-INT

• Early withdrawal penalties, such as those required for withdrawing money from a CD before its term is over, appear in Box 2. You can deduct these penalties as an adjustment to income on Schedule 1 of your Form 1040.
• If you had any federal or state income tax withheld, this is shown in Box 4 and Box 15 through 17. You can add this amount to other tax payments, such as withholding from wages or quarterly estimated tax payments.
• Investment expenses appear in Box 5. Most people can no longer deduct investment expenses since the Tax Cuts & Jobs Act of 2017 eliminated the ability to deduct these for the 2018 through 2025 tax years.
• If you paid foreign income taxes on any interest income you received, the amount paid and the country you paid the tax to appear in Boxes 6 and 7. You use this information to calculate your foreign tax credit.
• Specified private activity bond interest appears in Box 8. Private activity bonds are a type of muni bond meant to fund private projects with a public benefit, such as affordable rental housing. Interest income from private activity bonds typically isn't taxable, but it is necessary for computing alternative minimum tax.
• Boxes 10 through 13 deal with market discounts and bond premiums. These scenarios can happen when you buy an individual bond for less than or more than its face value. If you buy a bond at a discount, you're required to include a portion of the discount each year as taxable interest. If you purchased the bond at a premium, you're allowed to deduct a portion of that premium each year.

Where is taxable interest income reported on the tax return?

If you received more than $1,500 of taxable interest or dividends during the year, you report all of that interest and dividend income on Schedule B attached to your Form 1040. If your earnings didn't reach that threshold, you don't need to fill out Schedule B. Instead, you just report tax-exempt interest and taxable interest on lines 2a and 2b of your Form 1040.

Your 1099-INT forms should have all the info you need. They may not be complete, though. Banks and brokerage firms are only required to send you a form if they paid you more than $10 in interest during the year. So if you earned $5 in interest from a savings account, it's still taxable - you just might not get a 1099-INT.

So, it's a good idea to keep track of it yourself, too - because you're required to report all interest income on your return, no matter how small. If you have lots of accounts in various places, it could add up.

Is there any way to avoid taxes on interest income?

It's hard to avoid paying taxes on your interest income, but there are a few strategies to try, especially with assets that generate a lot of income.

• Keep assets in tax-exempt accounts, such as a Roth IRA or a Roth 401(k). No matter what the investment, you never owe taxes on anything earned in such accounts, as long as you obey the withdrawal rules.
• Keep assets in education-oriented accounts, like 529 plans and Coverdell education savings accounts. All earnings in these accounts are tax-free, as long as they're used for academic expenses.
• Invest assets in tax-deferred accounts, such as a traditional IRA or 401(k) to put off paying taxes until you withdraw the money in retirement, and you're presumably in a lower tax bracket.
• Invest in municipal bonds issued in your home state to qualify for the triple-tax-exempt treatment.
• Invest in US Treasuries to avoid state income taxes, especially useful if you live in a highly taxed locality.

The financial takeaway

No matter the source, most interest earned by your savings and investments counts as taxable income. It's taxed at the same rate as ordinary income - based on your regular tax bracket for the year.

Avoiding interest income tax boils down to seeking out certain exempt assets - mainly municipal bonds and US Treasuries - and using tax-advantaged accounts, in which money earns tax-free or at least tax-deferred.

The financial institutions holding your accounts send annual statements of your interest income called Form 1099. So keep track of these, and report all of your investment income. The IRS gets copies of all of your 1099s, so they'll know quickly if you leave anything out.

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