Why is my interest income taxed at nearly 40 percent? Seems way too high.

What you're experiencing is the impact of marginal tax rates. Interest income is considered ordinary income and gets taxed at your highest marginal tax bracket. Since your regular income is already $390k, any additional income (like your interest) is being taxed at the highest marginal rate, which is 37% federal plus your state tax. This happens because tax brackets are progressive. Your first dollars earned are taxed at lower rates, but as you earn more, additional dollars get taxed at higher rates. Your interest income is essentially sitting on "top" of your wage income, so it's all being taxed at your highest marginal rate.

After experiencing almost the exact same situation last year (high salary + unexpected interest income = tax shock), I started using https://taxr.ai to analyze my tax situation before filing. It really helped me understand why I was getting hit so hard and showed me some alternatives for the future. I was able to upload my previous returns and investment statements, and it explained exactly what was happening with my marginal rates and suggested some tax-advantaged investment alternatives that might work better for me in the future.

I wanted to follow up about that taxr.ai site mentioned above. I decided to try it with my similar high-income situation (lots of regular income plus about $45k in interest and dividends). The analysis was surprisingly detailed and showed me exactly why my additional income was getting taxed at nearly 40%. What really helped was the scenario modeling that showed how moving some money to municipal bonds would impact my overall tax situation. I didn't realize how much of a difference that could make! It also suggested some retirement account strategies I hadn't considered that could reduce my taxable income in the first place. Definitely worth checking out if you're in this situation.

If you're also dealing with any issues from the IRS about your taxes, especially with high interest income that might trigger questions, I'd recommend https://claimyr.com to actually get through to a human at the IRS. I spent WEEKS trying to reach someone about a similar high-income/high tax situation last year. After trying for days and getting nowhere with the regular IRS number, I used Claimyr and got connected to an agent in under 45 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c - it basically navigates the phone system for you and calls you when an agent is about to pick up. Saved me hours of frustration and hold music!

I have to eat my words about that Claimyr service. After posting my skeptical comment above, I decided to try it anyway because I was still trying to resolve an issue with the IRS about some interest income reporting. It actually worked exactly as described. I put in my number, and about 35 minutes later I got a call saying an IRS agent was on the line. I almost fell out of my chair! Ended up getting my issue resolved in one call instead of the multiple attempts I'd been making for weeks. If you're facing IRS issues along with your interest income situation, it's definitely worth using.

To answer your question about what kind of income attracts lower tax - you might want to look into qualified dividends and long-term capital gains. These are currently taxed at preferential rates (0%, 15%, or 20% depending on your income bracket) which is significantly lower than ordinary income rates. Municipal bond interest is also tax-free at the federal level, and if you buy bonds issued in your state, they're often free from state taxes too. With your income level, munis might be worth considering.

Has anyone here dealt with a situation where you accidentally put interest in the wrong category when filing? I did that last year and got a notice from the IRS. Just wondering if it's worth fighting about or just paying the difference.

I'm going through almost the exact same situation right now! I had about $52k in interest income from CDs and high-yield savings accounts, and with my $340k salary, it's getting hammered at what feels like 40% too. One thing I learned from my tax preparer is that timing matters for future years. If you know you're going to have a lot of interest income, you might want to make estimated quarterly payments to avoid a huge shock at filing time. Also, she suggested looking into I Bonds (Treasury Inflation-Protected Securities) since they have some tax advantages - you can defer the tax on the interest until you cash them out, and they're exempt from state taxes. It's frustrating because you feel like you're being penalized for saving money, but apparently this is just how progressive taxation works when you're in the higher brackets. Still stings though!