A savings account is a critical component of most people’s financial plans. Having extra funds in your savings account can provide a safety net in case of a financial emergency or help you reach a larger goal like homeownership.
Savings accounts are interest-bearing accounts that can help your balance grow faster thanks to the magic of compound interest. However, the interest you earn in a savings account is usually subject to income taxes, which you’ll need to address at tax time.
Do you owe taxes on your savings account?
The principal balance on your savings account is not subject to tax since you already paid taxes on that money before depositing it. However, the interest you earn on your savings account is considered taxable income.
For example, say you open a bank account that earns 4% APY and make a deposit of $1,000. After one year, you will have earned about $40 in interest (assuming your rate doesn’t change and you don’t make additional contributions).
The IRS considers that $40 of interest to be taxable income. So you would need to report those earnings on your tax return. In fact, any interest earned on your savings — whether through a savings account, money market account, certificate of deposit (CD), bond, or Treasury bill — is generally taxable. The same is true for any dividends or bonuses you receive.
The amount of taxes you pay will depend on your federal income tax bracket. There are few exemptions for certain savings account holders, such as those with low incomes.
How to pay taxes on your savings account interest
If you earned $10 or more in interest on your savings account, your financial institution will likely send you a Form 1099-INT or 1099-OID. These tax forms provide all the information you need to correctly file your tax return and report how much interest you earned in the past year.
If your bank didn’t automatically send you this form, you can contact them to request a copy. Keep in mind that you’re still expected to report all interest income, even if you don’t receive a form. Failing to report this information on your tax return could result in penalties or backup withholding.
In some instances, your financial institution may withhold taxes on interest income. In this case, you may be able to claim a tax credit on your return to get some money back if it withheld more than the required amount.
5 ways to shield your savings from taxes
Interest-bearing deposit accounts can boost your savings and are generally worth it, even if a portion of your earnings go toward taxes.
That said, there are other types of accounts that offer tax-free or tax-deferred ways to save. Depending on your goals, they could be worth exploring.
Individual retirement account (IRA)
A traditional IRA is a type of retirement savings account. Contributions are generally made pre-tax; you can lower your taxable income and reduce your overall tax bill by putting money in one.
Funds held in an IRA then grow tax-deferred until you begin making withdrawals from your account in retirement, at which point that money is taxed as ordinary income. This allows your investments to grow more significantly over time, thanks to compound returns.
This type of account can be a good option if your goal is to save for the future and you don’t intend to dip into those savings until you reach retirement age (making a withdrawal before retirement age comes with steep penalties).
Roth IRA
A Roth IRA is another type of retirement savings account. Contributions to a Roth IRA are made with after-tax dollars, so they won’t lower your taxable income for the current year. The plus side is that when you make withdrawals in retirement, you won’t have to pay taxes — including on the earnings. Similar to a traditional IRA, pulling out money before retirement age results in penalties.
401(k)
Many companies offer 401(k)s, a type of employer-sponsored retirement plan. You can elect to defer a portion of your salary to your 401(k) account, and these contributions are typically made pre-tax, reducing your taxable income for the year they’re made. Withdrawals are then taxed in retirement.
One major benefit some employers offer is matching contributions to their employees’ 401(k) plans, up to a certain percentage of their salary. This is essentially free money that can help you reach your goals even faster.
529 plan
If you’re saving for a child’s education, a 529 plan is a tax-advantaged account designed to encourage saving for future education costs. After-tax contributions to a 529 plan grow tax-deferred, and withdrawals for qualified education expenses are exempt from federal taxes. Many states also offer tax deductions or credits for contributions to a 529 plan.
Health savings account (HSA)
A health savings account allows those enrolled in a high-deductible health plan (HDHP) to save and pay for health expenses. You can elect to contribute pre-tax dollars to your HSA with each paycheck or deduct after-tax contributions on your tax return. Withdrawals from your HSA for qualified medical expenses are tax-free.
There are many types of savings vehicles, all with different benefits, drawbacks, and tax rules. When deciding where to put your money, carefully consider what you’re saving for and how often you’ll need to access your money.
If you’re saving for financial emergencies or a short-term goal, a high-yield savings account could be your best bet. The tax you’ll pay on earned interest may be a small price to pay for penalty-free access to your funds.
However, if you’re saving for a long-term goal, such as college or retirement, opting for a tax-advantaged account could help you save more money in the long run.