Accrued interest is taxable in almost every case, but the year you owe the tax depends on your accounting method and the type of investment. Most individuals report interest when they receive it. Several common instruments, though, force you to pay tax on interest that has accrued on paper before any cash reaches your account, and that mismatch is where investors get caught.
The Default Rule for Individuals
Nearly every personal return is filed on the cash method. Under the cash method, interest goes on your return for the year the money is credited or paid to you.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods A coupon check that arrives in December is 2025 income; one that arrives in January is 2026 income.
Businesses and other entities on the accrual method report interest as it is earned, whether or not the borrower has paid. For an accrual-method lender, interest becomes taxable the moment it accrues on the books.
Cash-method taxpayers cannot sidestep tax by leaving available interest untouched. Under the constructive receipt doctrine, income credited to your account or set apart for you without any substantial limitation counts as received.2GovInfo. 26 CFR 1.451-2 – Constructive Receipt of Income Interest a bank credits to your savings account or CD is taxable in the year of the credit, even if you never withdraw a dollar. If you could have taken it, you are treated as though you did.
A genuine restriction blocks constructive receipt. Funds frozen in a bank insolvency, or a CD with an early withdrawal penalty severe enough to eat into principal, can defer the tax until the restriction lifts. These are rare. The typical early withdrawal penalty on a multi-year CD is not a “substantial limitation,” so the interest is taxable each year as it is credited.
When You Owe Tax Before the Cash Arrives
The largest surprise in bond taxation is that some instruments require you to report interest annually even though you receive nothing until maturity. This is often called phantom income.
Original Issue Discount
A bond has original issue discount, or OID, when it is issued for less than its face value. A zero-coupon bond is the clearest example: you pay $600 for a bond that will pay $1,000 at maturity, and the $400 spread is interest built into the price.
Federal law requires holders of OID instruments to include accrued OID in gross income each year, whether they use the cash or accrual method.3Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount The annual amount is computed under a constant yield method tied to the bond’s yield to maturity, so the taxable slice rises each year as the adjusted issue price grows.4eCFR. 26 CFR 1.1272-1 – Current Inclusion of OID in Income
Your basis rises by the OID you include each year. That prevents double taxation at maturity: because you have already paid tax along the way, the gain on redemption is zero or near zero.
TIPS Inflation Adjustments
Treasury Inflation-Protected Securities behave similarly. The principal adjusts upward with inflation each year, and the adjustment is reported on Form 1099-OID as taxable income in the year it occurs, even though the higher principal is not paid until maturity. A 3% inflation adjustment on a $10,000 TIPS bond adds $300 of taxable income for that year on top of the small coupon. This is why many investors hold TIPS inside tax-advantaged accounts.
Buying a Bond Between Coupon Dates
When you buy a bond on the secondary market between interest payment dates, part of your purchase price reimburses the seller for interest that had accrued since the last coupon. That amount is purchased accrued interest, and it is not your income.
The seller reports that accrued interest as taxable interest on their return. When the next full coupon arrives in your account, a portion of it is simply returning what you paid to the seller. You subtract that amount from the interest you report.5Internal Revenue Service. Publication 550 – Investment Income and Expenses – Section: Accrued Interest on Bonds Only the remainder is your taxable interest.
Skip the adjustment and you pay tax on part of your own purchase price. Your brokerage confirmation should show the accrued interest paid at purchase, but the IRS will not make the correction for you. The subtraction happens on Schedule B, and you need the records to back it up.
Market Discount Bonds
Market discount is a different animal from OID and is often confused with it. A bond has market discount when you buy it in the secondary market for less than face value (or, for an OID bond, less than its adjusted issue price). The discount came from market conditions after issuance, not from the original terms.
The default rule is the opposite of OID: you do not owe tax on market discount each year. Instead, when you sell or redeem the bond, gain up to the accrued market discount is treated as ordinary income rather than capital gain.6Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income The accrued amount is usually figured on a straight-line basis over your holding period.
There is a de minimis exception. If the discount at purchase is less than 0.25% of face value multiplied by the full years remaining to maturity, it is treated as zero, and any gain is capital gain.7Office of the Law Revision Counsel. 26 USC 1278 – Definitions and Special Rules
You can also elect to include market discount in income annually as it accrues, treating it as interest each year. Some investors take that route to spread out the tax and to avoid rules that otherwise limit interest deductions on debt used to carry these bonds.
Savings Bonds Let You Choose
Series EE and Series I savings bonds give a choice most investments do not. The default is deferral: no interest is reported until the bond is redeemed, sold, or reaches final maturity.8Internal Revenue Service. Topic No. 403, Interest Received That can push the tax out for decades.
You can instead elect to report the interest each year as it accrues. The election, once made, applies to every savings bond you own and every one you later acquire, and it binds you in later years unless the IRS grants permission to change back.9Office of the Law Revision Counsel. 26 USC 454 – Obligations Issued at Discount Annual reporting can make sense in a low-bracket year or to avoid a lump-sum hit at redemption.
Municipal Bond Interest
Interest on state and local government bonds is generally excluded from federal gross income.10Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds That covers both regular coupons and accrued interest. Buying a muni between payment dates still involves paying the seller for accrued interest, but the amounts are tax-free on both sides.
The exclusion extends to OID on tax-exempt bonds: the annual OID accrual raises your basis but is not federal taxable income.11Office of the Law Revision Counsel. 26 USC 1288 – Treatment of Original Issue Discount on Tax-Exempt Obligations That is a real advantage over taxable OID bonds, where tax is due annually on cash you have not received.
Two limits are worth flagging. Interest from certain private activity municipal bonds may be taxable at the federal level and is often a preference item for the alternative minimum tax. Capital gains on munis are fully taxable, so tracking OID accruals still matters for figuring gain or loss at sale.
Reporting Interest on Your Return
Financial institutions report most interest on Form 1099-INT. Box 1 shows taxable interest credited or made available during the year, and Box 8 shows tax-exempt interest from municipal bonds. Box 8 is not taxed federally, but the IRS uses it in other calculations, including whether Social Security benefits are taxable.12Internal Revenue Service. About Form 1099-INT, Interest Income
OID from discount bonds and TIPS inflation adjustments appear on Form 1099-OID. Box 1 shows the OID that must be included in gross income for the year, and that number can be much larger than any cash interest received.13Internal Revenue Service. About Form 1099-OID If an issuer reports both stated interest and OID on the same bond, both may appear on a single Form 1099-OID rather than two separate forms.14Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
Schedule B Adjustments
If your 1099-INT includes purchased accrued interest that is not really your income, correct it on Schedule B of Form 1040. List the full 1099-INT amount, then below the subtotal enter “Accrued Interest” and subtract what you paid to the seller when you bought the bond.5Internal Revenue Service. Publication 550 – Investment Income and Expenses – Section: Accrued Interest on Bonds
A similar adjustment applies when you received interest as a nominee for someone else. Report the full amount on Schedule B, then subtract the other person’s share with the label “Nominee Distribution.”15Internal Revenue Service. Publication 550 – Investment Income and Expenses – Section: Nominee Interest You also need to issue a 1099-INT to the actual owner for their share if it meets the reporting threshold.
What Happens If You Miss It
The IRS receives every 1099-INT and 1099-OID your financial institutions file. Automated matching flags returns where reported interest does not line up, and this is one of the easiest discrepancies for the agency to spot.
If unreported interest produces an underpayment, the accuracy-related penalty is 20% of the underpaid tax attributable to negligence. The IRS treats leaving off income shown on an information return like a 1099 as an example of negligence.16Internal Revenue Service. Accuracy-Related Penalty The penalty comes on top of the tax and interest on the late payment. For OID bonds and TIPS the exposure is sharper, because the taxable figure may not match any cash you received and is easy to overlook.
Backup withholding is a separate mechanism. If you fail to give a financial institution a correct taxpayer identification number, or the IRS notifies the institution that you previously underreported interest, the institution must withhold 24% of interest payments before paying you the rest.17Internal Revenue Service. Publication 15 (2026), Circular E, Employer’s Tax Guide – Section: Backup Withholding The withheld amount counts toward your tax bill, but recovering any excess means filing a return and waiting for the refund.