Interest Rates Are Higher. Your Taxes Could Be Too.

Yields on the benchmark 10-year Treasury bond hit their highest level since 2007 earlier this month. These higher interest rates have been great for savers, but they could bring some unwanted liabilities come tax time. So, let’s look at how interest is taxed and the potential implications for your situation.

When it comes to taxes, the type of interest income and where you earn it matters. Interest earned in taxable accounts is generally, but not always, taxable at the federal marginal tax rates. For seniors, interest income can also impact the taxable amount of your Social Security benefits and what you will pay in future Medicare taxes. Interest earned in tax-preferred accounts like traditional and Roth IRAs is not taxable as long as it is not considered unrelated business tax income (UBTI). (Most IRAs will not have UBTI.)

Interest is different than dividends. Dividends are paid out of corporate earnings and, when qualified, are subject to the reduced tax rates of 0%, 15% and 20%.

Fully Taxable Interest

Interest that is fully taxable at the federal level is the most common type. This group includes typical banking products: interest-bearing checking accounts, savings accounts, money market accounts and certificates of deposit (CDs). Interest earned from money market funds and brokerage sweep accounts is also fully taxable. Corporate bond interest (aka, coupons) is taxable in the year it is received.

Partially Taxable Interest

Interest earned from traditional Treasury bonds is taxable at the federal level but not at the state level. Interest on Treasury inflation-protected securities (TIPS) is taxable in the year it is received, as is any increase in the principal value of TIPS. (Decreases in the principal of TIPS reduce income for that year.)

Interest earned on Series I bonds is deferred until the bond either matures or is sold.

Exempt From Federal Taxes

Municipal bond interest is exempt from federal taxes. Muni bond interest is also exempt from state taxes if it comes from bonds issued from your state. Interest distributed by muni bond funds and municipal money market funds is also exempt from federal taxes. It may or may not be exempt from your state taxes depending on the fund and your state.

This tax exemption makes it worthwhile to consider the tax-equivalent yield. The formula for calculating the tax-equivalent yield is tax-exempt yield ÷ (1 – your marginal tax rate). It is the comparable yield you would receive on a muni bond after tax advantages are considered.

Interest, Social Security Benefits and Medicare Premiums

There are additional considerations for those of you who are receiving Social Security benefits and/or are on Medicare.

The amount of taxable Social Security benefits is determined by your “combined income.” Combined income is your adjusted gross income (AGI, which includes all taxable interest at the federal level) plus nontaxable interest and one-half of your Social Security benefits. Nontaxable interest is interest earned from municipal bonds, muni bond funds and muni money market funds. If your combined income pushes you past the thresholds of $25,000 or $34,000 ($32,000 or $44,000 for married joint filers) for the current tax year, up to 50% and 85%, respectively, of your Social Security benefits will be taxable.

Medicare premiums are based on modified adjusted gross income (MAGI). MAGI, for purposes of Medicare premiums, is AGI plus tax-exempt interest income. As is the case with Social Security, interest earned from muni bonds, muni bond funds and muni money market funds is included. This can cause a Medicare beneficiary to pay more for premiums. Unlike Social Security, the impact is observed two years into the future. Your 2023 MAGI will determine what you pay in 2025 premiums.

None of these taxes should deter you from seeking out a higher interest rate, unless you are near a threshold and crossing it would result in a bigger tax liability than you would receive in interest income. In such cases, you may be able to offset the impact by realizing additional deductions.