- The interest you make on your savings is taxed just like your earned income.
- The taxes on your interest are based on your highest federal and state tax brackets.
- Your savings amount (principal) is not taxed.
- Interest rates on savings are very low and have declined historically.
- Alternatives to savings accounts include investing in the stock market, peer-to-peer lending, and crypto lending. These options come with a higher return potential but come with more risk.
If you’re a saver, you put your money into a savings account, which is a type of bank account that earns interest on your deposits that get paid out monthly. A bank or a credit union will offer this type of account, though the interest rate each will offer varies.
Perhaps you are a routine saver or getting started on your financial journey. No matter where you are, your savings account is a core part of your financial system.
As you save and receive your monthly interest payments, this begs the question: Do I have to pay taxes on my savings account? Let’s dive in to find out.
Paying Taxes on a Savings Account
Paying taxes is arguably one of the more overlooked aspects of personal finance. Whenever you get paid or earn interest, you owe the Internal Revenue Service (IRS) a portion of those earnings. Understanding how taxes can impact your financial plans has implications for your tax bill, potential investment returns, and individual retirement plans.
With your savings account, you pay taxes on the interest, not on the savings itself. Your savings deposit was already taxed as earned income when you received your paycheck. The interest earned is known as interest income, which is taxed a bit differently than the money you make from work called earned income.
The tax rate on your savings account’s interest income is based on your highest federal or state income tax bracket, also known as your marginal income tax rate. It’s how much you pay in additional federal or state income tax for every additional dollar you earn. For instance, if your highest federal tax bracket is 22% then you pay 22 cents for every extra dollar you earn in that tax bracket. The same logic applies to your state taxes.
So if you are a Californian and make $80,000 from work and $1000 in interest income, then you’ll pay 22% federal tax and 9.3% state tax on your interest. You’ll pay $220 in federal and $90.30 to California, making your total tax bill $310.30 or 31.3% on your interest. In essence, tax laws view your taxable interest income as ordinary income and charges tax based on that scale.
Banks make reporting your interest income easy as you receive tax form 1099-INT from them. This form details how much you made in net interest from your funds stored with the bank. You will receive a 1099 INT form for each interest-generating account you hold with each financial institution. Along with other taxable income sources, this form is reported to the IRS, your state’s tax agency, and you. Using a tax filing software like TurboTax or OLT.com, you can easily input the values from this form to calculate your taxable income and owed income taxes.
A Little Known Tax – Net Income Investment Tax (NIIT)
There’s a new tax called Net Income Investment Tax (NIIT), which is a 3.8% tax that applies if your Modified Annual Gross Income (MAGI) and Net Investment Income (NII) exceed the below thresholds:
- $200,000 for singles
- $250,000 for married couples filing jointly
- $125,000 for married couples filing separately
MAGI refers to the tax filer’s income adjusted for tax deductions and tax-exempt interest income. This figure is often used to determine if you’re eligible for tax benefits or government services.
For reference, net investment income is calculated as investment income from capital gains, rents, dividends, interest, etc., minus the expenses to generate them.
So if your MAGI is $200,000 and your NII is $10,000, then you’d pay $7,980 in NIIT tax.
NIIT applies to high earners and has a relatively low impact compared to taxes on earned income.
Different Types of Savings Accounts
There are two types of savings accounts – traditional savings account and high yield savings account (HYS).
Traditional savings accounts are held with brick-and-mortar banks such as Bank of America, Wells Fargo, Citi, and Chase. The interest rates offered by these banks are very low. For instance, Wells Fargo offers 0.01%, Citi offers 0.04%, and Chase offers 0.01%. If you deposit $1,000 and hold for a year, you would make 10 cents and 40 cents in interest, respectively. According to NerdWallet, the average interest rate is 0.06% APY. These savings accounts come with the benefits of FDIC protection, the use of physical ATMs, and in-person branches. Note that your local credit union may have higher interest rates than the bank.
A high yield savings account was created by the new wave of online banks such as Ally Bank and Synchrony Financial. These banks offer higher interest rates as both offer 0.5% APY – 8x higher than the average rate. If you deposit $1,000 and hold for a year, you would make $5 in interest. These savings accounts come with FDIC protection and online, no fees, and phone customer support.
Personally, I use high yield savings accounts over traditional ones as I was originally earning 2% APY with them. I expect their yields to rise in the future once interest rates increase. I also like keeping a division between checking and savings accounts as it helps me bucket my money for specific purposes.
Savings Account Interest Rates – Are They Worth It?
Currently, the prevailing interest rate is 0.50% APY, which is quite low. Over the last few decades, the average interest rate on savings accounts has fallen below 1%. The below chart illustrates the decline in interest rates on certificates of deposit (CDs) – which closely follow those for savings accounts.
These days, a saver is unable to fully preserve or grow the value of their money by leaving it in a savings account. Recently, inflation has been rising as coronavirus lockdowns ease up. According to YCharts, the inflation rate over the last year to June 2021 was 5.4%, contrasting the previous annual average rates of 2-3%. If you’re making 0.5% APY in interest, the value of your savings has still decreased by almost 5% over the last year. Given these conditions, are savings accounts still worth it?
Yes. Earning some interest is better than none and storing your savings in a separate account will help you stay accountable to yourself and your goals. Storing your money in different accounts for a specific purpose is a great way to manage your spending and keep your eye on the prize. Also, the account comes with FDIC protection.
Alternatives to Savings Accounts
Given the low interest rates, are there alternatives to using a savings account? Yes, and we’ve detailed a few of them below. Though, keep in mind that each of these comes with more risk than a savings account. But with higher risk comes the potential for higher rewards.
1) Investing in the Stock Market
The average annual return of the stock market is 10%, according to NerdWallet. A 10% return is 1,000x larger than the 0.01% interest rate offered by major banks. If you put $1,000 in the stock market and hold for 5 years, you could expect to make $610. The best way to invest in the whole stock market is through total market index funds, such as an S&P 500 index fund. However, you can also make less than 10% or even lose money in a given year.
2) Peer to Peer Lending
Lending isn’t just the banks’ game. People write loans to other people through online services such as Lending Club or Prosper where individual lenders and borrowers come together to fund personal loans. Investors or lenders deposit money that is lent out to those who need it. The borrowers pay back the principal each month with interest. This system works for both parties as borrowers pay less interest than they would to a bank and lenders make more interest than they would from saving with a bank.
However, your money is tied up until the borrower repays it in full and if they default, then you will not get your money back.
3) Crypto Lending
You can turn your dollars, pounds, or euros into cryptocurrency and earn interest. Using cryptocurrency exchanges you can convert your fiat currency into its stablecoin equivalent on a 1:1 basis. So you can turn $10 into 10 GUSD coins (Gemini US Dollar). Then, you can send your stablecoins to a crypto lender like Celsius, BlockFi, or Ledn that will loan your stablecoins out to a large financial institution, like a crypto exchange or brokerage that needs stablecoin to buy and sell other cryptocurrencies like Bitcoin or Ethereum. In turn, they will pay you interest on a daily, weekly, or monthly basis. For instance, Celsius offers 8.88% on US dollar stablecoins while BlockFi offers 7.5%.
However, there are risks such as increasing regulatory action from state and federal governments, hacks against the lenders, and risk of default. For more information, see our in-depth article on crypto lending.
Tax Implications of Alternatives
Buying and selling in the stock market will incur either short-term or long-term taxes. If you hold a stock for less than a year, then any gains are taxed like regular income from your job. You’ll pay tax at your highest tax brackets like you would for earned interest on a bank account. However, if you hold a stock for over a year then any gains will be taxed as long-term capital gains and subject to a more favorable tax scale. You can also deduct up to $3,000 in realized losses against your taxes each year.
Taxes on peer-to-peer lending work the same as if you are earning interest on your savings account.
Crypto lending is a mix of both tax schemes. At the time you are paid interest, you incur tax that is treated as interest on a savings account. If that interest is paid out in cryptos, such as Bitcoin or Ethereum, then you also incur taxes when you sell it or exchange it for another crypto. If you hold that crypto for at least a year, then you would be paying long-term capital gain taxes. With this schema, you are paying double taxes. However, the regulations around the crypto space are evolving fast and are subject to change.
The Bottom Line
Savings accounts are taxed on the interest they produce, not on the deposits. The highest state and federal tax rates apply (and the NIIT in some cases). There are two types of savings account – traditional and high yield savings, with the latter offered by online banks with higher interest rates. Though savings accounts see their interest outpaced by inflation, they are still low risk ways to set aside money for your goals or a rainy day.
Alternatives to savings account exist, but come with higher risk and include investing in the markets and various forms of lending. We hope we’ve given you an understanding of how your savings account is taxed and the other options you can use to preserve and build wealth on your financial journey.