Will you owe taxes on interest from savings accounts?

Your savings account is an essential part of your overall savings plan. For one, your savings is an investment — each time you deposit money into your savings account, you're actively investing in your financial security and well-being.

Your savings are also an investment since the money you put in your account earns interest. And because individuals must pay taxes on unearned income, you may owe taxes on the interest your savings account accrues.

Will I owe taxes on my savings account?

Because the IRS considers interest as taxable income, you have to pay taxes on your savings account’s earnings. Once the bank pays interest into your account equaling $10 or more in a calendar year, you will have to account for it on your taxes for that year.

Typically, your bank or credit union will send you tax form 1099-INT for the interest earned on your savings. But even if you don’t receive this form, you must report all interest income by law.

The IRS views the interest in your savings account as an addition to your earnings. For that reason, it taxes your interest at your earned income tax rate for the year, which currently ranges from 10% to 37%.

While you must pay taxes on the interest your savings account earns, you do not owe taxes on the entire account balance since you likely paid income taxes on the money before depositing it in your account.

The national average interest rate on traditional savings accounts, including conventional brick-and-mortar banks and credit unions, is just 0.06% APY, according to the Federal Deposit Insurance Corporation (FDIC). A high-yield savings account, on the other hand, can earn up to 10 times that amount. Check out your high-yield savings options via the Credible marketplace to boost your savings account earnings.

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Earned vs. unearned income

The IRS looks at two different types of income on your taxes: earned and unearned income. Let’s review these two sources of income:

Earned income. This is money you earn for performing work, either through employment or a business. If you make $75,000 as a nurse, that money represents earned income. Other forms include:

• Tips
• Bonuses
• Commissions
• Travel funds
• Meal reimbursements.

Unearned income. This is income outside of employment or a professional service, including:

• Interest
• Dividends
• Capital gain distributions
• Financial gifts
• Unemployment
• Social Security/pension distributions

Due to their unique income classifications, the IRS taxes these two types of income differently. You must classify your income correctly on your tax forms to avoid confusion and problems with the IRS.

Note that the various forms of unearned income are taxed differently. The IRS taxes interest on savings as if it were earned income.

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Can you avoid paying taxes on a savings account?

As discussed, most savings accounts earn interest and you must pay taxes on those earnings. However, there are a few types of savings accounts that are exceptions to this rule. You might consider these accounts if you’re looking to reduce your tax burden and stretch your savings.

IRA Savings

With a traditional individual retirement account (IRA), you can deduct your contributions from your income, lowering your tax burden for that year. Your money is tax-deferred until you take qualified retirement distributions. In the meantime, your funds grow tax-free until you retire.

Unfortunately, a contribution limit of $6,000 per year stifles your savings potential. If you’re over 50, you can deposit an additional $1,000 annually as a catch-up contribution.

Roth IRA Savings

By contrast, a Roth IRA account allows you to contribute after-tax dollars. That means you can make tax-free and penalty-free withdrawals after age 59 and a half, which is the most significant benefit of a Roth IRA if you figure you'll be in a higher tax bracket in retirement. And since your money was taxed before you deposited it, you won’t be taxed on the interest your account earns.

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The bottom line

If the money in your savings account earns more than $10 in interest, you must pay taxes on the amount of interest earned. Your financial institution should send you a 1099-INT form in the mail for tax purposes. Make sure to report your taxable interest on your Form 1040, even if the amount you earn seems insignificant. Failure to report all income sources could result in IRS fines and penalties.

If you’re not sure how to properly report all of your earned and unearned income on your taxes, you can seek the assistance of a qualified accountant.

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