Calculating tax on interest
About this video
Interest from bank accounts and CDs is usually taxed as ordinary income, while interest from federal or municipal bonds is not subject to federal tax. Building on a $45,000 taxable income example, the video shows that interest staying inside the 12% bracket is taxed at 12%, but interest that crosses into the 22% bracket is split between the two rates.
You'll be able to
- explain which kinds of interest are taxed as ordinary income.
- calculate the tax on interest income using my marginal tax rate.
- split extra income across two tax brackets when it crosses a bracket boundary.
- find the overall percentage of tax paid on interest that spans two brackets.
Key words
- Ordinary income
- Income such as wages or bank interest that is taxed using the normal income tax brackets.
- Marginal tax rate
- The tax rate on your next dollar of taxable income, set by the bracket you are in.
- Tax bracket
- A range of taxable income that is taxed at one particular rate.
- Taxable income
- Gross income minus deductions such as the standard deduction; the amount tax is calculated on.
- Municipal bonds
- Bonds issued by local governments whose interest is not subject to federal income tax.
Transcript
- [Instructor] So in many cases, when you get interest on your money, it's going to be taxed as ordinary income. The exceptions to that is if you're getting interest from, say, federal bonds or from municipal bonds, those aren't subject to federal taxes. But if you're getting interest on, say, your bank, the money that you have in a checking or a savings account, or a certificate of deposit, a CD, that's going to be taxed as ordinary income.
So let's build on an example that we've done in a previous video where you have $60,000 and let's just, this is before I calculate your tax on any interest, but your gross income before we calculate the interest. Maybe this is just from your job with $60,000. You're filing as an individual.
You have a $15,000 standard deduction, so your taxable income was $45,000. We've already talked about how the first $11,925 is going to be taxed at 10%. And then the increment above that, that gets us to $45,000 is going to be taxed at 12%. And then we added these two together.
This is the amount of taxes we're paying. You subtract it from $60,000, and then this was your take home pay. Now, let's add to that some interest. Let's imagine the scenario where you make, so let's call this scenario one, scenario one, you make, and I'm not picking this by accident.
Let's say you make $3,475 in interest. So this is the interest on your money that you're making. The reason why I picked that is the $45,000 of taxable income had put us in this 12% bracket. Now, just as a reminder, that's our marginal tax rate. We're not paying 12% on all of the $45,000.
We're just paying 12% on the amount above the 11,925. But as long as we're below 48,475 of taxable income, every increment incremental dollar we make of taxable income is going to be taxed at 12%. And so in scenario one, I essentially am going from $45,000 all the way to the top of this bracket, but all of this money, because we're staying in that bracket, is going to be taxed at 12% at my marginal tax rate.
And so how much am I going to pay in taxes in that scenario? Well, actually, let me put it right over here. So let me... So 3,475 times 0.12 is equal to, I'm going to pay $417 in taxes. So $417, and that's very clearly, 12% of what I made on that interest. And that's because that is my marginal tax rate and I'm not going over into another bracket.
Now let me go into another bracket in scenario two, scenario two. In this version, let's imagine that I made $4,475. Well, in this world, the first, the first... Let me do it this way. The first 3,475 is going to be taxed at 12%. That gets me to the top of this bracket.
And so, I'm going to pay the $417 on it. And then I have another $1,000 above and beyond this that's now going to be taxed in the next bracket. So this is going to be taxed at 22%. 22% of $1,000 is $220. And so we can see that this is now split. The first 3,475's is at $417 at 12%.
The next $1,000's at 22%. If I wanna see the percentage on the amount of interest I just got charged, I would add these two together. Let's see, that's $637, and 6,000, sorry, $637. Lemme get my calculator again. So, if I were to take $637 divided by 4,475, I am being taxed at 14%, 'cause it's a mix of these two brackets right over here.
So I'm being taxed at 14% to get $637. Now, this would've been a completely different calculation if my marginal tax rate were in a different place, or if I was close to a different boundary here. I might pay very different taxes here.
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