Interest is taxed at your regular income tax rate, not at a lower capital gains rate

Interest you earn — whether from a savings account, bond, certificate of deposit, or loan you made to someone else — counts as ordinary income on your federal tax return. The IRS taxes it the same way it taxes your salary or wages. If you are in the 22% tax bracket, interest is taxed at 22%. If you are in the 35% bracket, it is taxed at 35%. There is no preferential rate.

This matters because it makes interest less valuable than other types of investment income. When you sell a stock you have held for more than a year, you pay a lower capital gains rate — often 15% or 0% depending on your income. Interest gets no such break. A dollar of interest is worth less to you after taxes than a dollar of long-term capital gain.

The tax is due in the year you earn the interest, even if you do not withdraw the money. A bond that pays interest on December 31 creates a tax bill on that year's return, even if you do not cash it until January.

Key Takeaways

  • Interest income is taxed at your full ordinary income tax rate, with no preferential rate like capital gains receive.
  • You owe tax on interest in the year it is earned, regardless of whether you withdraw or reinvest it.
  • Banks and investment firms report interest to the IRS on Form 1099-INT, and you must report it on your tax return.
  • Interest from tax-exempt bonds (municipal bonds) is not subject to federal income tax, though state tax may still explore.
  • Accrued interest on bonds you buy between coupon dates is treated as ordinary income when you receive the next payment.

Where interest appears on your tax return

Interest income goes on Schedule B (Interest and Ordinary Dividends), which you attach to Form 1040. You list each source of interest separately if the total exceeds $1,500. If you have $1,500 or less, you can report it directly on Form 1040 without Schedule B.

The total from Schedule B flows into your ordinary income on the main return. It is added to wages, self-employment income, and other ordinary sources. This combined total determines which tax bracket you fall into.

Banks and brokers send you a Form 1099-INT by January 31 showing interest they paid you during the year. The IRS receives a copy. If you do not report the interest that appears on your 1099-INT, the IRS will notice the mismatch and may send you a notice or bill.

Why interest is taxed differently from investment gains

Congress created lower capital gains rates to encourage long-term investing and economic growth. When you hold a stock or mutual fund for more than a year and sell it for a profit, that gain qualifies for preferential rates: 0%, 15%, or 20% depending on your income level.

Interest, by contrast, is treated as compensation for lending money. The IRS views it the same way it views wages — income you receive for providing a service or asset. Because it is not a gain from selling an asset you owned, it does not may have access to for capital gains treatment.

This creates a real difference in your after-tax return. If you earn $1,000 in interest and $1,000 in long-term capital gains, and you are in the 24% tax bracket, you pay $240 on the interest but only $150 on the gain (at the 15% capital gains rate). The same $1,000 costs you $90 more in taxes straightforward because of how it is classified.

Tax-exempt interest and when it does not count

Interest from municipal bonds — bonds issued by states, cities, and local governments — is exempt from federal income tax. You do not report it on your federal return at all. Some municipal bonds are also exempt from state and local income tax if you live in the state that issued them.

Interest from U.S. Treasury bonds (issued by the federal government) is exempt from state and local income tax but not from federal income tax. You must report it on your federal return.

Interest from savings bonds (Series EE and Series I) can be deferred — you do not owe tax until you cash the bond or it matures. If you use the proceeds to pay for education, you may be able to exclude some or all of the interest from income, though this has income limits and other restrictions.

How accrued interest affects your tax bill

When you buy a bond between coupon payment dates, you pay the seller accrued interest — the interest that has built up since the last payment. This is not your interest income; it belongs to the seller. However, when you receive the next coupon payment, the full amount is reported to the IRS as your interest.

You must adjust for this on your tax return. You subtract the accrued interest you paid when you bought the bond, so you only report the interest you actually earned. If you do not make this adjustment, you will pay tax on interest that was not yours.

Keep records of the accrued interest you paid at purchase. Your broker may show this on your confirmation statement, or you can calculate it as (coupon rate × days held ÷ 365).

Interest from loans you made to others

If you loaned money to a friend, family member, or business and they are paying you interest, that interest is taxable ordinary income. You must report it even if the loan was informal or there was no written agreement.

The IRS has rules about minimum interest rates. If you loan money to a family member at no interest or below-market interest, the IRS may impute interest — treat it as if you charged interest even though you did not. This applies mainly to large loans and loans between family members. The minimum rate changes monthly and is published by the IRS.

If you forgive a loan, the forgiven amount may be treated as a gift (which has no tax consequence to you) or as income to the borrower, depending on the circumstances and whether you have already exceeded your lifetime gift tax exclusion.

How interest interacts with your tax bracket

Interest income is added to all your other ordinary income to calculate your total taxable income. This means interest can push you into a higher tax bracket, making it more expensive than it appears.

If you earn $50,000 in wages and $5,000 in interest, you are taxed on $55,000 of ordinary income. That $5,000 of interest is taxed at the marginal rate of your top bracket, not at an average rate. If the $5,000 pushes you from the 22% bracket into the 24% bracket, the interest is taxed at 24%.

This also affects other tax benefits. Higher ordinary income can reduce or eliminate deductions and credits you might otherwise claim, such as the child tax credit, education credits, or the ability to deduct IRA contributions. Interest that seems modest in dollar terms can have a larger tax cost when you account for these interactions.

Frequently Asked Questions

Do I have to report interest if it is less than $10?

The IRS does not require banks to issue a Form 1099-INT if interest is under $10, but you still owe tax on it. If you earned it, report it. The IRS matches 1099-INTs to returns, so if your bank issued one, you must report it or risk a notice.

What if I earned interest but did not receive a 1099-INT?

You still owe tax on it. Report the interest on Schedule B. If the amount was large enough that a 1099-INT should have been issued, contact the bank or financial institution and ask them to send one. If they do not, you may need to file an amended return once you receive it.

Is interest from a money market account taxed differently?

No. Interest from money market accounts, savings accounts, and checking accounts is all ordinary income taxed at your full rate. The account type does not matter — only the fact that it is interest.

Can I deduct interest I paid on a personal loan?

No. Interest you pay on personal loans, credit cards, and car loans is not deductible. Only interest on certain mortgages (up to $750,000 of principal) and student loans (up to $2,500 per year) can be deducted, and those have specific rules and limits.

How is interest taxed if I inherit a bond?

Interest earned after you inherit the bond is taxable to you in the year you receive it. Interest earned before the death is taxable to the estate or the previous owner. The step-up in basis at death applies to the bond's value, not to accrued interest.