Understanding Taxes on Interest Income: What You Need to Know
When it comes to earning extra cash from high-yield savings accounts, certificates of deposit (CDs), or other investments, it’s essential to understand the tax implications. The interest you earn on these investments may be subject to ordinary income tax, which can impact your wallet.
What Is Interest Income?
Interest income refers to the money earned from investments, such as corporate and municipal bonds, bank accounts, and more. This includes:
- Checking and savings accounts
- Certificates of deposit (CDs)
- Money market accounts
- Treasury bills, notes, and bonds
- Share accounts
- U.S. savings bonds
- Mutual funds
- Exchange-traded funds (ETFs)
- Corporate bonds
Taxation of Interest Income
Interest income and ordinary dividends are taxed at the same rate as your ordinary income tax. For example, if your federal income tax rate is 22%, your interest income or dividends will also be taxed at 22%. This means that you’ll need to pay federal tax on your interest income, unless your account is tax-advantaged, such as an individual retirement account (IRA) or 401(k).
Additional Taxes for High-Income Earners
High-income earners may also be subject to the net investment income tax, a 3.8% tax on interest, dividends, capital gains, and more. The 2023 income thresholds for this tax are:
- Single-filers or head of household: $200,000
- Qualifying widow(er) with a child: $250,000
- Married couples filing jointly: $250,000
- Married couples filing separately: $125,000
Reporting Interest Income
Before tax day, brokerages, banks, and financial institutions will send you a 1099-INT (for interest) or 1099-DIV (for dividends) form, which displays how much interest you’ve earned in the past year. Even if you don’t receive a form, you’ll still need to report the income, as it’s still taxable.
Minimizing Your Tax Burden
While it’s impossible to avoid paying taxes on interest income, you can consider investing in tax-advantaged accounts, such as 529 plans, health savings accounts, IRAs, and 401(k)s, to minimize your tax burden. Contributions to these accounts can reduce your taxable income.
Tax-Exempt Investments
Some investments, like municipal bonds, are exempt from federal interest income tax. Depending on your state of residence, you may also be exempt from state income tax. However, you’ll still need to report the interest earned on these investments to the IRS.
Preparing for Tax Season
Whether you’re saving for a down payment or investing in treasury notes, it’s essential to prepare for taxes on the interest you earn. Take advantage of tax-sheltered investment accounts, report all your earned interest and dividends, and avoid penalties from the IRS.
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