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How does the IRS tax interest income?

        Money | Taxes

You save some of your pay after tax ... but the interest you earn is taxed, too.
You save some of your pay after tax ... but the interest you earn is taxed, too.
MarkgrafAve/iStockphoto/ThinkStock

Whether it's from a financial planner or dear ol' dad, you've probably heard this advice over and over: Save some money for a rainy day. For most folks, savings starts with your paycheck – it's income you've already paid your taxes on, tucked safely away in an interest-bearing account. But after all that responsibility, you may be dismayed to learn that the interest you've earned on your little nest egg is subject to its own tax. Why, you may wonder, should the Internal Revenue Service get another shot at that money?

But think about it like this: While it's not exactly the same as standing out on the corner hawking lemonade, interest is still additional money you earned. And any money you earn is money that the government can politely pinch a piece of. The good news is that your interest isn't going to be taxed in any more interesting or complicated a manner than all your other income or earnings. Just like all your other money, it's taxed depending on what tax bracket you fall in.

In general, it's not going to be too difficult to figure out if you need to report your interest as income. If you're earning more than $10 of interest a year on any bank or financial account, the institution is required to send a 1099-INT statement to the IRS declaring your interest earnings [source: IRS]. Don't feel left out; they'll send you a copy too. When you file your taxes, you'll need to make sure your reported interest matches the bank's records. Your interest gets tallied up with the rest of your income, and the whole pile is taxed.

There are a few cases where interest is tax-exempt (at least on a federal level – state taxes might apply). Municipal bonds, private activity bonds and some dividends from mutual funds or regulated companies will be able to be gleefully pocketed without paying [source: Fidelity].


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