Many taxpayers may not realize that they need to pay taxes on the interest they accrue on loans, bonds, savings accounts, and more. To the government, almost all income is taxable income, but interest income is easy to forget or ignore. In short, if you’ve made money in interest, you’ll need to report it on your annual tax return. In this guide, we’ll explain what interest income is and when you’ll need to pay taxes on it.
What is interest income?
Interest received as income needs to be reported in your tax documents along with all of your other income. This might include the interest that you earned from a certificate of deposit (or CD), the interest you’ve made on a high-yield savings account, or some other form of interest that you’ve earned by offering a loan. Sometimes, this interest is forgotten as it’s a less obvious form of income than wages or side-gig (1099) earnings, but, if you’ve made money in interest, you’ll need to include interest income in your accounting.
Do you pay tax on interest income?
Most interest income is taxable, meaning that it should be reported as income on your tax return, with a few notable exceptions. Let’s investigate some common forms of taxable interest vs. tax-exempt interest income.
Taxable Interest Income
Generally, you should expect to pay tax on interest income. Here are some examples of situations where the interest you earn is taxable:
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- Savings/Checking Account Interest Income: This includes interest earned from savings accounts, checking accounts and other interest-beaing bank accounts. This is the most common form of interest income.
- Money Market Funds: Low-risk investment accounts that earn interest need to be reported as well.
- Dividends that are Interest: This includes dividends received from cooperative banks, credit unions, domestic building and loan associations, domestic savings and loan associations, federal savings and loan associations, and mutual savings bank.
- Certificates of Deposits (CDs): Interest income on a CD is taxable when interest is earned; it doesn’t matter when your CD matures.
- Interest on Tax Refunds: In some rare cases, the IRS will pay taxpayers interest on their refund. This must also be reported.
- Gifts for Opening an Account: Banks will often offer incentives and bonuses for opening a new account. This will be reflected in a 1099-INT.
- Below-market loans: For below-market loans, any forgone interest is reported as interest income.
- Interest of Insurance Dividends: When you leave dividends invested with an insurance company, the interest earned on this investment is considered interest income.
- Prepaid Insurance Premiums: Any increase in prepaid insurance premiums, advance premiums, or premium deposit funds is interest if applied as a payment.
- Seller-Financed Mortgage Interest: If a buyer makes mortgage payments to you (as the homeowner) directly, then you should expect to earn, and later need to report, interest.
Generally, the above types of interest income are all reported on form 1099-INT or the consolidated form 1099 (which reports the 1099-INT, the 1099-DIV, and 1099-MISC all in one form).
Tax-Exempt Interest Income
What interest income is not taxable? There are some rare forms of non-taxable or excludable interest. For example, interest on a municipal bond used to finance government operations is typically not subject to federal tax if issued by a state, District of Columbia, a U.S. possession, or any other political subdivisions. This is commonly referred to as Tax-Exempt Municipal Bond Interest which is Federally tax-exempt. States may tax interest on bonds issued by other states but exempt interest on municipal bonds issued by their own state. Tax exempt interest income appears on form 1099-INT in box 8 or 1099-DIV in box 11.
Unique Types of Interest Income
Some types of interest, such as savings bonds, are partially taxable and partially non-taxable, meaning that you’ll need to pay taxes on at least some of the money you make from a bond.
- U.S. Savings Bonds: Interest is payable when the taxpayer redeems the bonds. The difference between purchase price and redemption value is taxable interest. The interest is only tax-exempt for state income tax and when the costs are used for qualified higher education expenses. Learn more how treasury bonds work.
- Series EE Savings Bonds: This is the low-risk way to save and has a current interest rate of 2.7 percent.
- Series I Bonds: These bonds have changeable interest that changes every six months based on inflation.
- Original Issue Discount (OID): The original issue discount (OID) is a unique type of interest which usually occurs when bonds are sold at an initial discount. A debt instrument will generally have an OID when it’s issued for a price that is less than its stated redemption price at maturity. It’s the difference between the stated redemption price at maturity and the issue price. This is reported on IRS form 1099-OID.
- Bond Premium Amortization: If a bond has taxable interest, the taxpayer can elect to amortize the premium. This election takes a part of the premium to reduce the amount of interest included in income. Basis in the bond is reduced by the amount of amortization claimed. If the bond yields tax-exempt interest, the taxpayer must amortize the premium. Same impact as a bond with taxable interest. This is usually reported in boxes 10 through 13 on the 1099-INT.
- Market Discount Bonds: Sometimes, bonds issued through a secondary market are sold for an amount less than the maturity value. When the value of a debt obligation decreases after its issue date, it’s a market discount bond. The taxpayer may elect to accrue market discount over the life of the bond and include in interest income, this increases the taxpayer’s basis in the bond. This is usually reported on box 10 of the 1099-INT.
