If you earn interest income on your investments, in most cases you must pay tax on that income. Just like the income you earn from a paycheck, Uncle Sam also requires a piece of the income you earn from interest.
Even when it seems like the interest you earned is a very small amount, it’s still income—so you have to pay taxes on it. In short, taxable interest income is simply the money you earn on investments for which you’re required to pay taxes.
In most cases, your tax rate on earned interest income is the same rate as the rest of your income. So if your normal tax bracket is 25 percent, you’ll also pay 25 percent of interest in taxes.
Say you earned $1,000 in interest on a CD (certificate of deposit). If your tax rate is 25 percent, you’ll owe $250 in taxes from that income.
Remember, the percentage of tax you owe depends on everything on your tax return, such as income level, deductions, credits, exemptions and number of dependents. And because all those variables change, your tax rate can change from year to year. When your normal tax bracket changes, the amount of tax you pay on interest income changes along with it.
The interest you earn on federal bonds, mutual funds, CDs, and interest-bearing accounts is all taxable.
Interest on U.S. Treasury bonds, savings bonds and corporate bonds is generally taxable on your federal tax return at your regular tax rate. However, interest on U.S. Treasury bonds is usually exempt from taxes at the state and local levels.
Interest earned in mutual funds is taxable. But if the mutual fund is in a tax-deferred account such as a 401k or IRA, you won’t have to pay taxes on that interest right away.
The interest you are paid for CDs or for savings, checking and money market accounts is taxable at your regular tax rate in the year you earned it.
Municipal bonds are usually exempt from federal taxes, so you won’t have to pay tax on any interest earned through municipal bonds. In most cases, municipal bonds are also exempt from state and local taxes.
However, if you earn capital gains on a municipal bond, those gains are subject to federal and state capital gains taxes.
In most cases, tax on interest is due in the year it was paid to you. So, if you have an investment account that periodically pays interest and you leave the interest in your account untouched, you still have to pay tax on it for the tax year it was earned.
Most interest income is taxable once you receive it, or when you would be able to withdraw it. Even if you choose not to withdraw it, you still owe taxes on the interest as soon as it’s been paid to you.
The exception is when the interest is paid to you in a tax-deferred account such as a 401k or IRA. In those accounts, the tax you owe on interest and other earnings will be deferred until you begin making withdrawals from the account.
Banks and investment brokerage firms are required to send a 1099-INT to all customers to whom they pay more than $10 in interest over the past year. They’ll send a copy to you and to the IRS. This form reports the amount of interest paid to you over the year, which must be reported on your tax return.
When you receive a 1099-INT, you’re required to include that information on Schedule B of your tax return. The interest income reported on Schedule B should be added to your other income to determine your total taxable income.
Earning interest income is always a good thing. But because it increases your taxable income, don’t forget to pay taxes on that interest when owed.
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