There's a reason the IRS tends to get a bad rap -- it likes to stick its fingers into whatever earnings you manage to get your hands on. While we're all used to seeing taxes come out of our paychecks, many of us learn the hard way that interest income is also subject to taxes. Most of the interest payments you receive from bonds or your bank account are subject to federal taxes, and you're required to report your interest income on your tax return (Form 1040). In fact, some people end up owing money on their taxes because of their interest earnings.


Calculating and reporting interest income

Generally speaking, you need to pay taxes on interest income the year you receive it or it becomes available to you. You'll typically get a 1099 form listing the amount of interest income you received for the year provided that figure is $10 or more, and you're required to report that income and pay taxes on it when you go to file your return. And if you're thinking of conveniently forgetting to include that interest income on your taxes, think again. The IRS gets a copy of every 1099 form issued, so if you neglect to report that added income, it could raise a major red flag.

Types of taxable interest

The interest you receive from a bank, whether it's for a savings account, checking account (some actually pay interest), money market, or certificate of deposit (CD), is subject to taxes. The same holds true for bond interest in most cases, but not all. Corporate bonds -- those issued by companies -- are always taxable, so if you receive interest income from a corporate bond investment, you should prepare to pay the IRS its share. Treasury bond interest is also taxable, though not to the same extent. While you will pay taxes at the federal level, you'll avoid state and local taxes.

Savings bond interest is a bit more complex. Typically, savings bond interest is exempt from state and local taxes but subject to federal taxes. However, if you meet certain criteria, you can avoid paying taxes on interest from eligible Series EE and I Bonds issued after 1989 if you use the proceeds to pay for qualified higher education expenses.

Municipal bond interest

Municipal bonds have the opposite tax implications of Treasury and savings bonds -- their interest is always free from federal taxes. Furthermore, if you buy municipal bonds that are issued by your home state, you'll avoid state and local taxes as well. This triple exemption makes municipal bonds a favored investment among those looking to generate regular income while minimizing their tax burden.

Drawbacks to consider

The obvious downside to collecting taxable interest payments is losing a chunk of your earnings to the IRS. But the problem is further exacerbated by the fact that interest income is taxed as ordinary income, which means your interest payments are treated the same way as your typical paycheck. Throw in the fact that interest rates have been painfully low in recent years (particularly regarding standard savings accounts and the like), and it certainly makes the case for a more stock-focused investment strategy.

While stocks typically carry a higher risk than bonds, and buying stocks is unquestionably riskier than putting your money in an FDIC-insured savings account, if you hold your investments for more than a year and sell them for a profit, you'll be subject to a long-term capital gains tax rate that's lower than your ordinary income tax rate. Most taxpayers are currently only subject to a 15% long-term capital gains tax rate, with lower earners paying 0% and the country's highest earners paying 20%. 

Furthermore, if you buy dividend stocks, you'll benefit from regular, predictable income that's similar to bond interest, only less taxable. Though dividend income is classified as either qualified or non-qualified, much of it falls into the former category and is taxed at the more favorable long-term capital gains rate.

Imagine your ordinary income tax rate is 28%. If you receive $1,000 a year in corporate bond interest, you'll lose $280 of it to taxes. On the other hand, if you receive $1,000 a year in qualified dividend income, you'll lose just $150 to taxes.

Though collecting interest is a relatively safe way to make money, there are benefits to exploring alternate avenues for growing your wealth. And as an added bonus, you just might get to stick it to the IRS and keep more of that money for yourself.