If you currently have money sitting in a “traditional” savings account, you might be wondering whether it's worth moving your money into a high-yield savings account. After all, compared to the average interest rate of roughly 0.5% on a traditional savings account, a high-yield account typically yields a rate of 4% or more. And, as you can probably imagine, that difference can add up in a big way.
At the same time, before you open a high-yield savings account, it's important to understand how taxes work on these accounts so you can plan accordingly and avoid problems down the road.
Is Your Savings Balance Taxed?
One common misconception about high-yield savings accounts to debunk from the beginning is that the entire balance of a high-yield account is taxed. In reality, this simply isn't the case. Instead, taxes on a high-yield account apply only to the interest you earn.
This means if you put $10,000 into a high-yield savings account that earns 4% interest during the year, you won't be taxed on that $10,000 principal balance. Instead, you're taxed only on the money you earn in interest. In this case, then, you'd be taxed on the $400 you earn in simple interest.
Understanding Taxes on Savings Interest
For tax purposes, interest earned on a high-yield account is treated as any other type of income. This means that when you go to file and pay your taxes for the year, any interest you accumulated in a high-yield savings account will be added to your taxable income and taxed based on your applicable income tax rate (which can vary depending on your tax bracket).
With this in mind, the exact amount of interest you'll have to pay on your high-interest yields will vary depending not just on your tax bracket and income tax rate, but other factors as well. This may include your filing status, any deductions for which you are eligible, tax credits, and more.
The Importance of Reporting Your Interest
No matter how much (or how little) you may have made on your high-yield savings account in any given year, you are legally bound to report it (and pay any applicable taxes) to the IRS when you file your tax return. All too often, taxpayers make the mistake of thinking they don't need to report seemingly small or insignificant interest earnings.
In reality, financial institutions that pay out interest are required to report this interest on Form 1099-INT. A copy of this form goes to you, but it is also filed with the IRS. This means that if you fail to report any interest earned (even if it's just $20 over the course of the year), you could end up facing an investigation by the IRS.
Consider, too, that your state may have separate requirements for reporting and paying interest on a savings account—so you'll need to do your research and follow the rules where you live.
Tips to Reduce Taxes Owed on Savings Interest
While there aren't any special tricks that will alleviate your tax burden on savings interest, there are some tax strategies you may be able to deploy as a means of allocating your hard-earned money more wisely.
For example, you might consider putting some of your money into a 529 plan, a health savings account (HSA), or even a tax-advantaged retirement account in lieu of a high-interest savings account. Often, these accounts are tax-deferred or offer other tax advantages. Just keep in mind that these kinds of accounts may also come with strict rules regarding how funds can be used in order to retain tax benefits. HSA funds, for instance, may only be used to pay for qualifying health expenses.
Is a High-Yield Savings Account Right For You?
For many taxpayers, putting money into a high-yield savings account can be a great way to generate a passive income—but, like any type of income, there are tax obligations to consider. At the end of the day, you'll need to be prepared to report all interest earned and pay taxes on it—no matter how much (or how little) you earn over the course of the year.
Likewise, your interest earnings are only one part of the picture when it comes to your taxes and income, so it's always a good idea to consult with a tax professional to understand your specific obligations.
If you have questions about whether a high-yield savings account may be right for you, please contact our tax services team.