Interest

Interest is income you receive from a debt instrument (such as a bond). When you buy a bond, you’re lending money to an issuer, and the issuer pays you interest in return.

Unlike dividends, interest generally doesn’t receive favorable tax treatment. That said, the tax rules depend on who issued the bond, and some interest may be exempt from certain taxes.

Keep in mind that only the interest portion of a bond payment is taxable income. Repayment of the bond’s principal is simply a return of the investor’s own capital, so it’s never taxed.

As a reminder, here’s the tax status of different types of bond issuers:

US Government debt

• Subject to federal taxes
• Exempt from state and local taxes

Mortgage-backed securities

• Subject to federal, state, and local taxes
• Each pass-through payment is a mix of principal (a non-taxable return of capital) and interest (taxable at the federal, state, and local levels)
• For example, holders of agency (Fannie Mae, Freddie Mac, Ginnie Mae) mortgage-backed pass-through securities receive a monthly statement from the issuer/servicer that breaks each distribution into interest (taxable), scheduled principal or amortization (non-taxable), and unscheduled principal or prepayments (also non-taxable) - since both types of principal are simply a return of the investor’s own capital when the security was purchased at or near par

Municipal debt

• Exempt from federal taxes
• Subject to state and local taxes
• 100% tax-free if:
  • Resident
  • Territory bond

Corporate debt

• Subject to federal, state, and local taxes

If taxes are due, the federal tax rate applied to interest is the investor’s federal marginal income tax bracket. Interest is taxed the same as non-qualified dividends (as discussed in the previous chapter). As of the tax year 2026, these are the income tax brackets for individuals and those filing jointly:

Rate	Individuals	Married filing jointly
10%	$0	$0
12%	$12,401	$24,801
22%	$50,401	$100,801
24%	$105,701	$211,401
32%	$201,776	$403,551
35%	$256,226	$512,451
37%	$640,600	$768,700

Do not memorize these tax brackets; this chart is only for context.

Definitions

Marginal tax bracket

The tax bracket applied to the last dollar earned

Example: An individual making $55,000 would pay a 10% tax on the first $12,400 earned, a 12% tax on additional income up to $50,400, and a 22% tax on the remaining income. Even though the investor pays multiple rates across different portions of income, their marginal tax bracket is 22%.

State taxes depend on the state, and you don’t need to know the specifics. Interest is reported annually on form 1099-INT.