Savings accounts are federally insured, just like a checking account is. However, they offer high annual percentage yields (APYs) to grow your money over time, low minimum opening deposit requirements, and few monthly fees. High-yield savings accounts offer even higher APYs than traditional savings accounts, making them desirable to reach personal finance goals.
A high-yield account could be beneficial if you're looking to pay off student loans, save for retirement, make a sizeable real estate purchase or capitalize on regular income. It's important to bear in mind, however, a high-yield savings account's tax implications. Any interest earned on your money is taxable and must be reported on your tax return.
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How savings accounts are taxed
The interest you earn on your traditional or high-yield savings account is considered taxable income. You won’t pay interest on your deposits, but you will pay a savings account tax on any interest you accrue during the year, which the Internal Revenue Service (IRS) considers ordinary income.
This interest is taxed at your earned income tax rate. And, it doesn’t matter if you keep the money in the account, withdraw it, or transfer it to another account altogether – it’s still taxed. If the IRS discovers you’ve earned interest on a savings account that you didn’t report, you could get hit with fees. The IRS may even decide to look into this further to determine if it was a mistake or an act of fraud.
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How to file taxes on savings account interest
When you file your annual income tax return, the interest you earn on your savings account(s) is shown on a 1099-INT tax form. You will likely receive this tax form in the mail for income earned. You are still expected to report that income even if you don’t receive a 1099-INT, but only if the interest earned is more than $10.
Banks, credit unions, and other financial institutions must show any interest they pay to account holders to the IRS. The IRS will verify the interest income you report on your taxes against what is reported by your bank to ensure there are no discrepancies. You won’t need to attach a copy of your 1099-INT form that you receive, but you do need to include the information on your tax return.
Besides the federal government, 43 states also collect income tax. You are required to pay taxes on the interest you earn on the savings account the same as you do on any income you make during the year if you live in one of these states.
Searching for a tax-free savings account? Try an IRA
Both savings accounts and individual retirement accounts (IRAs) can be used to stash away money for the future. Savings accounts are ideal to meet short-term financial goals. IRAs are designed to help you prepare for retirement.
The main benefit of an IRA over a savings account is that interest income on savings accounts is taxable. Contributions to many IRAs are tax-deductible, allowing your savings to grow faster. But, withdrawals from your IRA are taxed depending on the type of IRA you have.
There are several types of IRAs: Roth, SEP or SIMPLE, and traditional IRAs. Deposits to traditional IRAs are tax-deductible, and your money grows tax-free. But if you make withdrawals from your IRA, you may owe income tax on that money.
Contributions to Roth IRAs are not deductible on your taxes, but withdrawals are tax-free (if you’ve had a Roth for a minimum of five years). Keep in mind that if you make early withdrawals before the age of 59½, you will likely pay a 10% penalty plus taxes.
When you choose a traditional savings account, a high-yield savings account, or an IRA, you can invest money in your future. If an emergency arises, you want to pay off debt or you're working on retirement planning, you have peace of mind you can still make ends meet.
But, unlike an IRA, any interest you earn on the money in your savings account is considered taxable income, and the tax you pay is determined by your overall taxable income for that same year.
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