Are Savings Accounts Taxed by IRS?

It’s tax season, which means you may be scrambling to get your return filed. As you’re pulling together receipts and income statements, you might be wondering what kinds of income you have to pay taxes on.

Got a W-2 from your employer? You can add that to your list.

The same goes if you’re self-employed or an independent contractor who receives 1099 forms. But what else is considered taxable income?

If you’ve got some cash tucked away in a savings account, you might be surprised to learn that you have to pay taxes on the interest you earn.

Reporting the interest on your savings isn’t optional and all taxpayers are required to pay their fair share to Uncle Sam.

Quick answer: Yes, you will get taxed on the interest earnings on your savings accounts.

Read on to learn more about how your savings account is taxed.

Tax Rules for Traditional Savings Accounts

The Internal Revenue Code outlines the rules for taxation of interest income. The IRS considers most interest that’s paid to you to be taxable income.

If you have taxable interest from a savings account, this would be reported on Form 1099-INT.

These forms are usually mailed out at the end of January and they’re different from Form 1099-MISC. That type of 1099 is used to report miscellaneous income.

For example, if you do freelance work on the side of your regular 9-to-5 gig, any money paid to you would show up on a 1099-MISC.

The minimum threshold you have to hit to receive a Form 1099-INT is $10.

That doesn’t mean, however, that you can skip out on reporting interest income from a savings account below that amount. The IRS requires you to report all taxable interest in your income, even without a Form 1099-INT.

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What types of interest income are taxable?

The IRS decides which kinds of interest income are taxable. Currently, you have to pay interest earned on:

• Bank accounts, including interest-bearing checking accounts and savings accounts
• Money market accounts
• Share accounts with credit unions
• Certificates of deposit
• Corporate bonds
• Deposited insurance dividends
• Treasury bills, notes, and bonds
• Savings bonds
• Any interest paid to you by a business that’s $600 or more

That’s a pretty broad list, so if you’ve got any of those types of accounts, you’ll have to account for any interest earned on your taxes. On the flip side, there are some types of interest income that you may be able to exclude from your taxes. Those include:

• Interest redeemed from Series EE and Series I bonds issued after 1989 if you’re using the money to pay for qualified higher education expenses
• Interest on certain municipal bonds
• Interest on insurance dividends left on deposit with the U.S. Department of Veterans Affairs

If you’ve got any of these types of interest income, you may want to check with a tax pro to find out whether they’re taxable.

What about new account bonuses?

Some banks offer an incentive to get customers to open a new savings account.

For example, you may be able to snag a few hundred dollars in cash when you open an account and meet the bank’s minimum requirements.

It may seem like you’re getting money for nothing but there’s a catch. Any cash bonuses you get are considered fair game by the IRS.

The same is true for any cash referral bonuses you received for referring friends and family. As long as it’s over $10, any bonuses will show up on a Form 1099-INT.

If you’re thinking about opening a new checking, savings or money market account to snag a big bonus, just remember that you’ll be paying part of that money back to the IRS when it’s time to file taxes.

Tip: Cash back and points earned on a rewards credit or debit card aren’t classified as taxable interest by the IRS.

Is interest income taxed differently than regular income?

When it comes to income, the IRS doesn’t just lump it all together. Some income is earned while some is unearned. Earned income is money you make from working. It includes:

• Wages
• Salaries
• Tips
• Net earnings from self-employment
• Union strike benefits
• Certain types of long-term disability benefits
• Payments from certain types of deferred compensation plans

Unearned income, on the other hand, is money that’s paid to you that you don’t earn. In this category, you’d find:

• Annuity payments
• Pension income
• Retirement account distributions
• Capital gains from investments
• Dividends
• Income generated by rental properties you own
• Bond interest
• Stock dividends
• Alimony
• And last but not least, interest income

Earned and unearned income are taxed differently. With earned income, you’re paying three specific types of taxes: payroll tax (which includes Social Security and Medicare taxes), federal income tax, and state income tax.

These are the taxes your employer takes right off the top before you get your paycheck.

With unearned income, you’re not paying the payroll tax. For most types of unearned income, you’d just pay your ordinary income tax rate.

That rate is determined by how much taxable income you earn for the year. So, for example, if you fall into the 25% tax bracket, you’d pay that rate on any interest income from your savings.

Why You Have to Pay Taxes On Your Savings

The Internal Revenue Code is designed to ensure that people aren’t shortchanging the government.

In the eyes of Uncle Sam, income is income, regardless of where it comes from. And income, even if you technically didn’t earn it, is generally taxable, including interest on your savings.

The good thing about having to pay taxes on your savings interest is that you only have to do it once per year.

With certain types of income, you have to make estimated payments against what you owe in taxes every quarter.

We mentioned freelance income reported on Form 1099-MISC earlier.

If you’ve got a side hustle or you’re self-employed, you’d be responsible for making tax payments four times a year.

Not only do you have to pay income tax on those earnings but you also have to pay self-employment tax.

If you don’t pay enough in taxes, you could hit with a penalty when you file your return.

What Happens If You Don’t Report Taxable Interest?

You could also be staring down a penalty if you don’t report all of your interest income for the year.

The IRS takes underpayment of taxes very seriously and even if it’s just $1.00 in interest income, you should still report it anyway.

If the IRS looks at your return and determines that you didn’t pay enough in taxes because you left off some of your interest income, you could be a bill in the mail for what you owe.

Each month you have unpaid taxes, the IRS charges a penalty of 0.5% of the amount due. They can also tack on fees until you pay in full.

Even a seemingly small amount of interest could turn into a big problem if you don’t report it. The best way to head off a run-in with the IRS is to report all your interest income each year.

Tax-Free Savings Accounts

You'll get some tax advantages with an IRA savings account. Simply put, it combines the features of an individual retirement account (IRA) with a savings account.

An IRA is a type of retirement savings account. You can save money in an IRA on top of what you’re putting into an employer’s retirement plan.

Another option is an IRA CD. IRA CDs work like other certificates of deposit.

You purchase the CD for a set period of time. The CD earns interest. Once the CD matures, you can roll it over into a new CD or into an IRA savings account.

You could simply withdraw the funds in your IRA CD but you’ll have to pay taxes plus a penalty on the money if you’re under age 59½.

IRA Savings

An IRA savings account still earns interest and it’s still subject to the same Regulation D rules for withdrawals. (In case you don’t know, Regulation D limits you to six withdrawals from a savings account per month.)

IRA savings accounts can be set up as Traditional or Roth accounts. A traditional IRA savings account is tax-deferred.

That means that you wouldn’t pay taxes on any earnings in the account until you withdraw the money in retirement.

If you pull the money out prior to age 59 ½, you’d owe taxes on the withdrawal, plus a 10% early withdrawal penalty.

The Roth savings option lets you enjoy tax-free growth. Once you retire, you can withdraw your original contributions and any earnings without paying a dime in taxes on the money.

There’s just one slight hitch. IRAs, including IRA CDs and IRA savings accounts, are subject to annual contribution limits.

For 2020 and 2021, the limit is $6,000. There’s an extra catch-up contribution of $1,000 allowed if you’re 50 or older.

With a regular savings account, there’s no cap on how much you can save.

If you’re trying to decide between parking your money in a regular savings account versus an IRA savings account, just remember to weigh the tax advantages against the contribution limit. Or, you could open one of each to enjoy the best of both worlds.

Roth IRAs

There are two basic types of IRA: traditional and Roth. With a traditional IRA, you may be able to deduct the money you contribute.

That’s good if you’re in a higher tax bracket and want to reduce your taxable income.

When you reach retirement age and start taking money out of the IRA, you pay taxes on the interest earned.

Again, you’re taxed at your regular income tax rate. Once you turn 70½, you’re required to take minimum distributions from your traditional IRA.

A Roth IRA is a little different. With a Roth, you don’t get a deduction for what you put in. Your contributions are made with after-tax dollars.

The benefit is that when you retire, you can take out your contributions and your earnings tax-free. That’s good if you expect your income to be higher later in life.

There’s also no required cutoff date for taking distributions so you can let your money grow as long as you want.

What's Different About IRA Savings Accounts

The same tax rules for IRAs (and the limits on annual contributions) apply to traditional or Roth IRA savings accounts. There are, however, two main differences between IRA savings accounts and regular IRAs.

With an IRA savings account, your money grows only by earning interest. A regular IRA, on the other hand, offers the potential to earn much higher returns because you can invest those funds in stocks, bonds, mutual funds, and more.

That ties into the second major difference. Because the money in your IRA savings account isn’t invested in stocks or mutual funds, you’re not subject to the kind of risk that usually entails.

With such investments, you could lose all your money. In other words, you may earn a lower rate of interest on an IRA savings account but you’re going to be much safer doing it.

Focused on retirement savings

Both an IRA savings account and an IRA CD can help you build up savings for retirement. You won’t have to pay taxes on the interest you earn until you withdraw the money in retirement.

In terms of the interest rates, they’re likely to be pretty comparable to what you’d earn with a non-IRA savings account at an online bank.

If you’ve got more than one savings goal, you could set up an IRA savings account to save for the future and defer taxes.

You could also put money into a regular high-yield savings account so you have cash that’s readily available when you need it. You’d just have to pay taxes each year on the interest you earn in that account.

Where Can You Find IRA Savings Accounts?

If you’re interested in adding an IRA savings account to your savings plan, the key is finding the right bank. Any bank could offer an IRA savings account. That doesn’t mean you should open up the first IRA savings account you come across, however.

Two of the most important things to consider are the interest rate the bank is offering and what fees they charge for IRA savings account. You might find that a monthly service fee eats into your earnings.

Some banks may waive the monthly fee if you maintain a minimum balance.

You'll find the best IRA savings accounts at online banks, rather than a brick-and-mortar bank or credit union. Online banks tend to have lower overhead costs. That means they save money.

The savings are passed on to customers in the form of higher interest rates on savings and minimal fees.

Know what you're getting

The other thing to think about is whether a traditional IRA savings account or a Roth IRA savings account makes more sense.

If you normally land in a higher tax bracket, getting a deduction for the money you save in a traditional IRA savings account could cut down on your tax bill.

The main drawback is that you’d have to pay taxes on it later on and you couldn’t leave the money in your account indefinitely.

A Roth IRA savings account doesn’t come with the upfront tax break; you get one on the back end instead.

For some savers, being able to skip out on paying taxes later on may be more beneficial. Another upside to a Roth IRA savings account is that as long as you’re working and have income, you can keep adding to it.

Finally, be sure to check out the minimum deposit required to open an IRA savings account.

Some banks may set the bar relatively low, at a few hundred dollars. Others may require you to pony up $1,000 or more to open your account.

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Is an IRA Savings Account Right for You?

A tax-free savings account would work for you if you meet the following criteria:

• You want to cut the taxes paid on interest earnings
• You have a low risk tolerance
• You have a long time frame before you need this money

Otherwise, you're simply better off with one of the best online savings accounts that provide interest rates with no monthly fees. Remember, these accounts let you access the savings in the event of emergencies.

Consider Your Savings Options Carefully

Knowing that you’re going to pay interest on your savings shouldn’t keep you from building up your emergency fund or setting aside money for your dream vacation.

If anything, it should motivate you to find an account that’s going to offer the highest savings yield possible.

As you’re checking out different accounts, be sure to compare the fees to make sure you’re not paying more than you need to for a higher rate.