Taxes on Interest

Nearly every source of income is taxable, including income that is not actively earned, such as interest paid on saving accounts and investments. Interest is sometimes taxed differently than earned income (such as wages), depending on the type of investment.

Earned income is often referred to as ordinary income and is usually the income that the taxpayer received from employment. Most interest income is taxed at the same rate as ordinary income. Interest income also contributes to the tax bracket in which the IRS classifies the taxpayer. This means that interest from investments can push them into a higher tax bracket in certain situations.

Interest that is taxed at ordinary income levels often includes the following sources:

Interest paid is reported on a 1099-INT. Taxpayers should receive this form from each financial institution who has paid interest over $600 to them during the calendar year. Even if the taxpayer does not receive a 1099-INT, they are still required to report the income on their tax return. A Schedule B may be required if the taxpayer has taxable interest income over $1,500.

Interest That is Not Taxed as Ordinary Income

Certain types of interest may be tax-exempt for federal tax purposes. This includes municipal bond interest. Investments in bonds that help state, city and county governments. The local government may use the funds raised by the sale of municipal bonds for schools, sewer systems, highways and other public projects. The Internal Revenue Service does not tax interest accumulated on these bonds and many states do not tax these as well.

A similar bond that is not taxed at the federal level is a "private activity bond." This bond is also issued by local governments, but it is designed to provide financing for private companies that are engaging in certain qualified projects. If the bond is issued in the state where the taxpayer resides and files their tax return, the state typically does not tax the received interest payments, but that is not always the case for out-of-state bonds.

For information on the other types of income that you may need to report on your tax return, see this page.