Is Interest Taxed as Ordinary Income?

With tax season almost around the corner, it’s time to figure out what you might owe (or not) to the IRS on your 2022 proceeds. Those earnings might include wages and salaries, income received from rental properties, fund distributions, profit from an investment property sale, or interest received on investments.

You probably already know that wages are taxed at ordinary income rates. Meanwhile, that profit you earned from selling an investment property will be taxed as a capital gain. But where does interest fit into the picture?

According to the IRS, interest from bank accounts, money markets, certificates of deposit, corporate bonds, and deposited insurance dividends are taxed as ordinary income. But like other tax-related issues, there are caveats to this rule of thumb.

What is Interest?

Interest expense is what you pay for using borrowed money. You know about interest expense if you used a mortgage to buy a house. Your repayments include the principal plus the interest expense. This is the extra that a lender tacks on for giving you the money to buy (or refinance) your home.

The same principle is at work when you buy a bond, put money into a savings account, or invest in a certificate of deposit. In this case, you’re lending funds to an entity that issues bonds or owns the savings accounts and CDs. In return, those entities pay you interest for use of that money. Depending on the investment, your interest payout might occur monthly, quarterly, or upon maturity.

You’ll receive notification of interest income on a Form 1099-INT or Form 1099-OID. These forms are also filed with the IRS.

What is Ordinary Income?

Ordinary income is defined as income received from providing goods or services to another party. As mentioned above, wages and salaries make up ordinary income. So do royalties, unqualified dividends, short-term capital gains, and interest income.

Putting the Two Together

Interest income is taxed at the same federal rate as earned income. But there are some situations in which interest might be exempt from the federal income tax. They are as follows:

• Interest on municipal bonds
• Private activity bonds
• Exempt-interest dividends from a mutual fund or other regulated investment company

Another consideration is that interest income might be taxable in states with state income tax. But interest income from Treasury bills, notes, and bonds are exempt from state and local income taxes (though they are subject to federal income tax).

The takeaway here is that any interest income you receive on investments will generally be taxed as ordinary income. Be sure to keep an eye out for all 1099-INT and 1099-OID forms and include those amounts as you prepare your taxes.