Interest Income

Interest income is what you earn when you lend money — to a bank, the U.S. Treasury, a corporation, or a municipality. Unlike dividends, which are discretionary distributions from corporate profits, interest is a contractual obligation: the borrower must pay it according to a fixed schedule or the loan is in default. Interest income is predictable, which makes it attractive for retirees who need stable cash flow. It is also taxed less favorably than qualified dividends or long-term capital gains — almost always as ordinary income at your full marginal rate — which makes tax location and instrument selection critical decisions.

What Investments Pay Interest

High-Yield Savings Accounts and Money Market Accounts

Savings accounts and money market accounts at banks and credit unions pay interest on cash deposits. High-yield savings accounts (HYSAs) at online banks have historically tracked the federal funds rate closely — rising substantially in 2022–2023 as the Fed hiked rates to 5.25%–5.50%, and falling as rates came down. Interest is credited monthly and reported on Form 1099-INT. It is fully taxable as ordinary income at the federal and state level with no special treatment.

Certificates of Deposit (CDs)

CDs are time deposits where you lock up cash for a fixed term — 3 months to 5 years — in exchange for a guaranteed interest rate. The rate is fixed at purchase regardless of what interest rates do afterward. Interest accrues and is taxable in the year it is earned, even for multi-year CDs where cash is not paid until maturity — a phantom income issue discussed below. Early withdrawal penalties reduce but do not eliminate the interest income reported.

U.S. Treasury Securities

Treasuries are the largest component of most fixed income portfolios and have a uniquely favorable state tax treatment: interest on Treasury bills, notes, bonds, and TIPS is exempt from state and local income tax, though it is fully taxable at the federal level. For high-income residents of California (13.3% top rate), New York City (combined ~14.8%), or other high-tax states, the state exemption makes Treasuries meaningfully more attractive on an after-tax basis than equivalently yielding corporate bonds.

• Treasury bills (T-bills): Maturities of 4, 8, 13, 17, 26, and 52 weeks. Sold at a discount to face value; the difference is the interest income, reported on Form 1099-INT at maturity.
• Treasury notes and bonds: Maturities of 2, 3, 5, 7, 10, 20, and 30 years. Pay semiannual coupon interest, reported annually on 1099-INT.
• TIPS (Treasury Inflation-Protected Securities): Inflation adjustments to the principal are taxable as interest income in the year they accrue — even though you do not receive the cash until maturity. This phantom income makes TIPS poorly suited for taxable accounts. See the Mistakes section below.
• I Bonds: Series I savings bonds sold directly by TreasuryDirect.gov. Interest accrues but is not taxable until the bond is redeemed — a rare deferral advantage. Additionally, I Bond interest is state-tax-exempt. However, purchase limits are $10,000 per person per year ($20,000 per couple), limiting their scale.

Corporate Bonds

Corporate bonds pay semiannual interest (the coupon) and are fully taxable at federal and state rates — no special exemptions. Investment-grade corporate bonds (rated BBB/Baa and above) offer higher yields than Treasuries in exchange for credit risk. High-yield (junk) bonds offer still higher yields with substantially higher default risk. For taxable accounts, the after-tax yield on corporate bonds is often less competitive with Treasuries than the pre-tax spread suggests, because Treasuries benefit from state tax exemption while corporate bonds do not.

Municipal Bonds

Municipal bonds (munis) are issued by state and local governments to finance public projects. Their defining feature: interest is exempt from federal income tax. Additionally, if you purchase munis issued by your own state, the interest is typically exempt from state income tax as well — making in-state munis effectively triple-tax-exempt for state income tax purposes.

Because of the federal exemption, munis pay lower nominal yields than taxable bonds of comparable maturity and credit quality. Whether a muni is better than a taxable bond depends on your marginal rate. The taxable equivalent yield formula converts a muni yield to its taxable equivalent: Taxable Equivalent Yield = Muni Yield ÷ (1 − Marginal Tax Rate). A muni yielding 3.5% is equivalent to a 5.83% taxable yield for someone in the 40% combined marginal rate bracket — making it attractive. For someone in the 22% bracket, the same muni is equivalent to only 4.49% — potentially uncompetitive with available Treasuries or CDs.

Munis are generally appropriate only for high earners in taxable accounts. Holding munis in a traditional IRA or Roth IRA wastes the tax exemption entirely: IRA withdrawals are taxed at ordinary income rates regardless of what generated the income inside the account, so the federal exemption that makes munis valuable disappears.

Bond ETFs and Mutual Funds

Bond funds distribute interest monthly as dividends, reported on Form 1099-DIV in Box 1a (ordinary dividends) rather than on 1099-INT. Despite the label, these are economically interest payments and are taxed as ordinary income. The tax treatment follows the underlying bonds: a Treasury bond ETF's distributions carry the state tax exemption for the Treasury interest portion; a municipal bond ETF's distributions are federally exempt to the extent they come from qualifying muni interest. Your broker's year-end tax statement will typically break out the exempt percentages.

Money Market Funds

Money market funds hold short-term high-quality debt instruments — T-bills, commercial paper, repurchase agreements — and distribute income daily, credited monthly. Government money market funds (holding primarily Treasuries and agency securities) pass through partial state tax exemption on the Treasury component. The percentage varies by fund; most fund providers publish annual state-by-state tax exemption percentages for each fund.

How Interest Income Is Taxed

With limited exceptions, interest income is taxed as ordinary income at your full marginal federal rate — the same rate that applies to wages, bonuses, and traditional 401(k) withdrawals. There is no preferential rate for interest income equivalent to the 0%/15%/20% rates that apply to qualified dividends and long-term capital gains.

The 2026 federal ordinary income brackets that interest income flows into:

• 10%: $0–$11,925 (single) / $0–$23,850 (MFJ)
• 12%: $11,926–$48,475 / $23,851–$96,950
• 22%: $48,476–$103,350 / $96,951–$206,700
• 24%: $103,351–$197,300 / $206,701–$394,600
• 32%: $197,301–$250,525 / $394,601–$501,050
• 35%: $250,526–$626,350 / $501,051–$751,600
• 37%: Above $626,350 / $751,600

Additionally, the 3.8% Net Investment Income Tax (NIIT) applies to interest income when MAGI exceeds $200,000 (single) or $250,000 (married filing jointly). A high earner receiving taxable interest income faces up to 40.8% federal tax on that income before state taxes.

Exceptions and Special Cases

• Municipal bond interest: Exempt from federal income tax. Exempt from state tax if issued in your home state. Not subject to NIIT. Does appear in MAGI for ACA and IRMAA calculations — a common mistake discussed below.
• Treasury interest: Fully taxable at the federal level; exempt from state and local income tax.
• I Bond interest: Federal taxable when redeemed (you can also elect to report annually). State and local tax exempt. Can be excluded from federal tax entirely if used for qualified higher education expenses and income qualifies.
• U.S. Savings Bond interest (Series EE): Same rules as I Bonds — federal taxable at redemption or annually by election, state exempt, education exclusion available.

Common Mistakes With Interest Income

1. Holding TIPS in a Taxable Account

TIPS pay phantom income: the inflation adjustment to the principal is taxable as interest income in the year it accrues, even though you do not receive the cash until maturity. In a year when inflation runs at 4%, a $100,000 TIPS holding generates approximately $4,000 of taxable interest income that you cannot spend. You pay real cash taxes on income you have not received. TIPS are almost always better held inside a tax-advantaged account — traditional IRA, 401(k), or Roth IRA — where the phantom income creates no current tax cost.

2. Holding Municipal Bonds in a Retirement Account

Munis are valuable because their interest is federally tax-exempt. Inside a traditional IRA, that exemption is irrelevant: all withdrawals are taxed as ordinary income regardless of source. You have effectively converted tax-free income into taxable income by routing it through a retirement account. Inside a Roth IRA, the muni exemption is also wasted — Roth growth is already tax-free, so you gain nothing from the muni exemption while accepting the lower yield that compensates non-retirement investors for the tax benefit. Munis belong in taxable accounts for high earners, nowhere else.

3. Ignoring the State Tax Exemption on Treasuries

High-tax-state residents who compare Treasury yields to CD or corporate bond yields on a pre-tax basis are making an apples-to-oranges comparison. A 5% Treasury yield in California nets 5% after state tax; a 5% CD yield nets 4.335% after California's 13.3% top rate. At high income levels, Treasuries may offer a meaningfully better after-tax yield than seemingly higher-yielding alternatives — but only if you correctly account for the state exemption. This comparison is especially relevant when choosing between Treasury money market funds and bank savings accounts or CDs.

4. Phantom Income on Multi-Year CDs

Some CD structures — particularly "zero-coupon" CDs or CDs that compound interest internally and pay at maturity — generate original issue discount (OID) income that is taxable each year as it accrues, not just when you receive the cash at maturity. If you hold a 5-year CD that pays all interest at maturity, you may owe tax on accruing interest every year without having received any cash to pay the bill. Read the CD terms and your 1099-OID carefully.

5. Forgetting That Tax-Exempt Interest Affects MAGI

Municipal bond interest is exempt from federal income tax — but it is not exempt from MAGI. For ACA health insurance subsidy calculations, tax-exempt muni interest is added back to AGI to compute MAGI. For IRMAA Medicare surcharge calculations, the same add-back applies. An early retiree carefully managing income below an ACA subsidy cliff may unknowingly push over the threshold if their portfolio generates significant muni bond interest — even though none of it shows up on their 1040 as taxable income. This is one of the most commonly overlooked MAGI traps in early retirement income planning.

6. Chasing Nominal Yield Without Comparing After-Tax Returns

A 5.5% corporate bond yield is not better than a 4.8% Treasury yield for a California resident in the 32% federal bracket. After-tax Treasury yield: 4.8% × (1 − 32%) = 3.26% federal tax, plus 0% state = 3.26% net. After-tax corporate yield: 5.5% × (1 − 32% − 13.3%) = 5.5% × 54.7% = 3.01% net. The "lower yielding" Treasury is actually worth more after tax. The correct framework for comparing fixed income is always after-tax yield, not nominal yield — and for high earners in high-tax states, this comparison often dramatically changes which instruments are most attractive.

7. Not Accounting for Interest Income in ACA and IRMAA Planning

For early retirees managing income below ACA subsidy thresholds or Medicare IRMAA tiers, interest income from high-yield savings accounts, CDs, and bond holdings can be the difference between qualifying for a subsidy and losing it. Unlike qualified dividends, which can sometimes be harvested at 0% and managed around thresholds, interest income cannot be deferred or characterized differently — it is ordinary income in the year it accrues. Building a fixed income portfolio without modeling its MAGI impact is an incomplete plan.

8. Holding All Fixed Income in Tax-Deferred Accounts Without Considering Roth

The conventional advice — hold bonds in tax-deferred accounts, stocks in taxable — has important nuances. Placing interest-generating bonds in a traditional IRA does shelter the ordinary income from current tax. But it also means those future IRA withdrawals are ordinary income, potentially at a high rate in retirement. Placing high-growth equities in a Roth IRA allows that growth to compound and be withdrawn tax-free. The optimal location strategy considers not just current tax rates but projected future rates, RMD exposure, and the relative growth rates of different asset classes across account types.