Things you might not have learned in school but should know about: Types of interest and how it works - interest we earn

"Earned interest" refers to the income you receive from allowing someone else to use your money. It's the return you get on your investments or deposits. Think of it as the opposite of the interest you pay on a loan or credit card; instead of being a cost, it's a benefit.

Where You Earn Interest

You can earn interest from various sources:

• Savings Accounts: Banks pay you interest for keeping your money deposited with them.
• Certificates of Deposit (CDs): These are time deposits where you agree to keep your money locked away for a specific period in exchange for a fixed interest rate.
• Bonds: When you buy a bond, you're lending money to a government or corporation, and they pay you interest (often called "coupon payments") in return.
• Money Market Accounts: These are similar to savings accounts but often offer slightly higher interest rates, though they might have minimum balance requirements.
• Loans You Make: If you lend money to another person or business, and they agree to pay you interest, that's earned interest for you.
• Interest-bearing Checking Accounts: Some checking accounts offer a small amount of interest, though typically less than savings accounts.

How Earned Interest is Calculated

The calculation of earned interest depends on whether it's simple or compound interest:

• Simple Interest: Calculated only on the original principal amount.
  • Formula: Principal × Rate × Time
  • Example: If you deposit $1,000 in an account earning 5% simple interest annually, you'd earn $50 per year.
• Compound Interest: Calculated on the original principal and any accumulated interest from previous periods. This means your money earns "interest on interest."
  • The frequency of compounding (daily, monthly, quarterly, annually) significantly impacts how much interest you earn. More frequent compounding generally leads to higher earnings.
  • Example: If you deposit $1,000 at 5% annual interest compounded annually:
    • Year 1: You earn $50 interest. Your balance is $1,050.
    • Year 2: You earn 5% interest on $1,050, which is $52.50. Your balance is $1,102.50. (Notice you earned more in year 2 because the interest from year 1 was added to the principal for the new calculation).
    • This "power of compounding" is a key concept in long-term saving and investing.

Earned Interest and Taxes

In most cases, earned interest is considered taxable income and must be reported on your federal income tax return.

• Ordinary Income: Most interest earned from savings accounts, CDs, corporate bonds, and money market accounts is taxed as ordinary income. This means it's added to your other income (like wages) and taxed at your regular income tax bracket.
• Form 1099-INT: If you earn $10 or more in interest from a financial institution (like a bank), they will typically send you a Form 1099-INT at the end of the year, reporting the total amount of interest paid to you. You must report all taxable interest on your tax return, even if you don't receive a 1099-INT.
• Tax-Exempt Interest: There are some exceptions where interest may be tax-exempt:
  • Municipal Bonds: Interest earned on bonds issued by state or local governments (municipal bonds) is generally exempt from federal income tax, and sometimes from state and local taxes if you live in the issuing state.
  • U.S. Treasury Interest: Interest from U.S. Treasury bonds, notes, and bills is taxable at the federal level but is exempt from state and local income taxes.
  • Tax-Advantaged Accounts: Interest earned within tax-deferred accounts like Traditional IRAs or 401(k)s isn't taxed until you withdraw the funds, typically in retirement.
  • Reporting: Taxable and tax-exempt interest are reported on your Form 1040 (lines 2a and 2b). If your taxable interest is above a certain threshold (currently $1,500), you may also need to file Schedule B (Form 1040).

In essence, earned interest is the financial reward you receive for being a lender or for simply saving your money in an interest-bearing account. Understanding how it's calculated and taxed is important for effective personal finance management. Investing in accounts with interest, especially compounding interest, can help combat the effects of inflation on your retirement funding. For more detailed information and a personalized recommendation, please contact our office.