How your savings accounts are taxed

It is an excellent practice to keep money in high-yield savings account for any short-term goal, where your money will be safe, accessible, and growing. But if you save money in the traditional savings account, chances are you are not making enough money due to the current low-interest rate environment. However, you won't get to keep all the interest you earned from either savings account because interest earned is considered taxable income by the (IRS) Internal Revenue Service. You have to report savings account interest on your tax return every year.

This article will help you to learn all you need to know about how and when saving accounts are taxed and how to avoid tax on saving accounts.

Understanding Tax on Savings Account

Most people do not consider savings accounts to be investments. However, they earn revenue in the form of interest, and regardless of whether you keep the money in the account, move it to another account, or withdraw it, the interest on them is considered taxable income by the IRS.

In contrast, you will owe taxes on the interest when the bank deposits it into your account for that year. You would owe taxes on the $100 if, for instance, you have a balance of $20,000 in a Marcus by Goldman Sachs savings account with a 0.50% annual percentage yield (APY) and you are paid $100 in interest yields over a year.

Interest that is earned from a savings account is taxed at your annual earned income tax rate. In other words, it is taxed as though it is an increase in your earnings. These rates were between 10% and 37% as of the 2021 tax year.

Interest income is also subject to a separate tax known as the net investment income tax if your net investment income (NII) or modified adjusted gross income (MAGI) is higher than a specific threshold.

Does your savings account balance matter?

Your account balance will be a factor when calculating the amount of taxes you owe because of your savings account. Your balance does affect the amount of interest you earn, even though it isn't directly taxed. The larger your savings account balance, the more interest would accumulate and the more tax you have to pay.

How to file taxes on a savings account?

The interest you get from your savings account(s) is reported on a 1099-INT tax form when you submit tax forms of your yearly income tax return. Financial institutions are required to issue you a 1099-INT form if you earned more than $10 in interest during the tax year. You might not get a 1099-INT if the interest you earned from any one account was less than $10, but you must still report the interest to the IRS and pay any taxes owed on it.

How to calculate tax on interest from a savings account?

Interest earned from a savings account is taxed at your annual earned income tax rate. As a result, your yearly interest tax liability will be determined by your total taxable income, your current tax rate, and the amount of interest you earned.

The marginal tax brackets for the 2022 tax year are as follows:

Suppose you're a single filer, and your total taxable income is $50,275 in 2022. You earned $50,000 from your wages and $275 through interest from a savings account. For the first $10,275, your tax rate would be 10%, for the next $31,500, it would be 12%, and for the remaining $85,000, the tax rate would be 22%.

Remember that the variables determining your tax bracket can vary yearly—the standard tax bracket changes with a change in the tax amount that you pay on interest earnings.

How can I avoid tax on a savings account?

There are a few options for tax-free savings accounts that you should take into account if you want to minimize your tax liability plus boost your savings.

• Put your money in a tax-deferred account (or accounts), like a typical IRA or 401(k), to delay paying taxes til you withdraw the funds in retirement.
• Keep your cash in an account or accounts that aren't taxed, such as a Roth IRA or a Roth 401(k) (k). These accounts can be used to withdraw earnings tax-free after retirement because they are funded using after-tax dollars.
• Keep your money in an education-oriented account, such as Coverdell education savings accounts and 529 plans. Also, all earnings in these accounts are tax-exempted as long as the money is spent on academic expenditures.
• Invest in state-issued municipal bonds. Municipal bond interest is exempt from federal, state, and local taxes as long as the investor resides in the state where the bond was issued to promote investment in local government projects.

Bottom line

While an interest-yielding savings account is an excellent choice to start your savings strategy, you can maximize your earnings by using a variety of savings accounts that meet different demands. Consult a tax professional to help you choose which savings account is best for you.