How interest income is taxed

When your savings account, CD, or bond pays interest, that money is generally taxable income — even if you never withdrew it and it just compounded in the account. As interest rates climbed, millions of savers who'd never thought about it started receiving Form 1099-INT and owing tax on interest for the first time. The rules are simple once you know two things: most interest is taxed like your paycheck, and where the interest comes from decides which governments get a share.

Most interest is ordinary income

Interest from savings accounts, money market accounts, CDs, and corporate bonds is 'ordinary income' — taxed at your regular federal bracket, the same rate as wages. There's no preferential rate like long-term capital gains get. It's taxable in the year it's CREDITED to you, not when you withdraw it, so a savings account that compounded $600 of interest owes tax on that $600 this year even if you left every penny in the account.

The exceptions that change the rate — or skip it

Two patterns fall out of that table. Treasury interest and US savings bonds are exempt from STATE income tax — a real edge for savers in high-tax states, since a Treasury bill and a bank CD at the same rate aren't equal after state tax. Municipal bond interest goes the other way: exempt from FEDERAL tax (and often state tax if you buy your own state's bonds), which is why high earners in high brackets favor them. That federal exemption is also why you compare munis to taxable bonds using a 'tax-equivalent yield,' not the headline rate.

Where to shelter interest

Because interest is taxed annually at ordinary rates, it's one of the least tax-efficient forms of income to hold in a taxable account. That's the logic behind asset location: bond and cash holdings that throw off interest belong in tax-deferred accounts (a traditional IRA or 401(k)) where the annual tax drag disappears, while tax-efficient stock index funds live in taxable accounts. You can't do this with an emergency fund you need liquid, but for long-term bond allocations it quietly matters.

The bottom line

Interest is generally ordinary income, taxed at your bracket in the year it's credited — reinvested or not — and reportable even when it's under the $10 that triggers a 1099-INT. The exceptions are worth money: Treasury and savings-bond interest skips state tax, and municipal bond interest skips federal tax. Compare after-tax yields, not headline rates, and hold interest-heavy assets in tax-advantaged accounts where you can. It's some of the simplest income to tax and some of the easiest to accidentally under-report.