Understanding Taxes on Interest Income

If you’ve stashed money in high-yield savings accounts or certificates of deposit (CDs) to earn extra cash, it’s important to be aware that the interest you earn may be subject to taxes. Interest income is money earned from various investments and bank accounts, including checking and savings accounts, CDs, money market accounts, and more. This article aims to provide insights into how interest income is taxed, what accounts and investments are subject to tax, and how to report interest income correctly.

Interest Income Taxation:

Interest income and ordinary dividends are typically 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%. It’s important to note that interest income is subject to taxation at both the federal and state levels.

For high-income earners, an additional tax known as the net investment income tax may apply. This is a 3.8% tax on various forms of income, including interest, dividends, and capital gains. The income thresholds for this tax in 2023 vary depending on your filing status.

Reporting Interest Income:

Financial institutions, including brokerages and banks, will typically send you a Form 1099-INT (for interest) or Form 1099-DIV (for dividends) before the tax deadline. These forms display how much interest or dividends you’ve earned in the previous year. Keep in mind that brokerages only send these forms to taxpayers who earn more than $10 worth of interest. Even if your earnings are below this threshold, you are still required to report the income because it is taxable.

Taxpayers earning more than $1,500 in interest or ordinary dividends must also fill out Schedule B (Form 1040) to provide additional details.

Accounts and Investments Not Subject to Tax on Interest Income:

While it is generally impossible to avoid paying taxes on interest income, some taxpayers may consider investing in tax-advantaged accounts, such as 529 plans, health savings accounts (HSAs), individual retirement accounts (IRAs), and 401(k)s, to minimize their tax burden in other ways. These accounts offer various tax benefits, but they often come with restrictions on how funds can be used.

Municipal bonds, issued by state governments, are an exception. Interest earned from municipal bonds is typically exempt from federal income tax. Depending on your state of residence, you may also be exempt from state income tax on these bonds. However, it’s crucial to report any interest earned on municipal bonds to the IRS.

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Understanding the taxation of interest income is essential for individuals looking to maximize their earnings and stay compliant with tax regulations. While you cannot entirely avoid paying taxes on earned interest or dividends, utilizing tax-sheltered investment accounts, like Roth IRAs, can help you save money. Make sure to report all your earned interest and dividends accurately to avoid potential penalties from the IRS.

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