If you keep money in a regular savings account, you will generally have to pay federal income taxes on the interest you earn. You’ll pay taxes at the regular rate the year the interest is earned, whether or not you withdraw from the account. You can avoid paying taxes on interest with the help of some tax-advantaged accounts used to finance retirement, healthcare and education expenses. However, these accounts come with restrictions that make them unsuitable for storing emergency savings. To help you decide how to save for various purposes while minimizing your tax burden, talk to a financial advisor.
Savings Account Interest Tax Basics
Conventional savings accounts offered by most banks, credit unions and some other financial institutions, including online banks, are ideal for saving money for short-term needs. They often have some restrictions on the number of monthly withdrawals, so they are not suitable for paying regular bills like checking accounts. But their owners can easily access funds when needed and face low and sometimes no monthly service costs.
One downside is that even high-yield savings accounts pay only modest interest, rarely enough to keep pace with inflation. And, to make matters worse, the Internal Revenue Service expects its owners to pay income taxes on the interest earned. Taxes are applied at owners’ regular tax rates based on income and must be paid even if interest is left in the account rather than withdrawn and spent.
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Is it possible to avoid taxes on savings account interest?
In most cases, it is not possible to avoid the tax you are required to pay on the interest earned on your retirement account. Most places where you park your money, especially safe places to keep your money like a savings account, require you to pay taxes on the interest you earn. Once you reach the $10 threshold, it will be reported to the IRS and you will not be able to avoid paying the tax.
However, there are two ways to avoid paying taxes on the interest earned on your savings account. Both ways involve saving your money in a tax-advantaged account and not a regular savings account. The two types of tax-advantaged savings accounts you should look for are:
An account that allows you to deposit money before taxes.
An account that allows the money in the account to grow tax-free.
Tax-advantaged savings accounts
Now let’s take a closer look at each type of savings account you might choose if you’re trying to avoid taxes on interest. None of the accounts offer the same flexibility as a conventional savings account, but they can save you quite a bit on taxes if you have a substantial amount to save. The main tax-advantageous savings account options are:
Roth Individual Retirement Account (IRA) or Roth 401(k): Interest earned in a Roth account is not taxed until it is withdrawn. And, if you’re over age 59 1/2, you won’t have to pay any income tax on the interest. However, early withdrawals before age 59½ incur a 10% penalty on top of any income tax due. Contributions to Roth accounts have already been taxed, so they can be withdrawn at any time without taxes or penalties.
Traditional IRAs and non-Roth 401(k) accounts.: These accounts don’t have to pay taxes in the year the interest is earned, like regular savings accounts do. However, when interest is withdrawn, it is taxed as ordinary income. Interest withdrawals or previously untaxed deposits before age 59½ are also subject to the 10% penalty in addition to being taxed as regular income.
Coverdell Savings Accounts: These are designed to help parents pay for the educational expenses of their minor children. Interest earned on funds in a Coverdell account can be withdrawn interest-free, but only if the money is used to pay eligible educational expenses.
529 College Savings Plans: A 529 plan allows interest on deposits to grow tax-free and also allows tax-free withdrawals when the money is spent on eligible educational expenses.
Health Savings Accounts (HSAs): An HSA allows its owners to deduct their contributions from current income and also avoid paying taxes on earnings and withdrawals. However, the money must be spent on qualified medical expenses.
Flexible Spending Accounts (FSAs): Another popular account, an FSA, allows owners to deduct contributions from current income and also avoid paying taxes on the interest if the money is used for qualified medical expenses. FSA funds generally must be used in the year they are paid.
It can be difficult to choose which of these options might be right for your needs, but you don’t have to make this decision alone. You can work with your financial advisor to determine the best fit for your financial landscape. Additionally, none of these plans are exclusive. You can use each with one or more other accounts to maximize the benefits of each.
Income taxes are generally due on any interest earned from a savings account, but there are ways to avoid paying these taxes. The special tax treatment of some accounts intended to encourage saving for retirement, education and health care exempts interest from taxes both when it is earned and, often, when it is withdrawn. However, these accounts also have significant limitations, including restrictions on the timing and use of withdrawn funds. For this reason, conventional savings accounts are still useful for emergency savings and short-term savings.
Tax planning tips
A qualified financial advisor will help you decide how to best use various savings options to meet your financial needs. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisors at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goals, start now.
You are required to report any interest earned from a savings account on your tax return. And keep in mind that the IRS already knows how much interest you received. Banks report any interest payments of $10 or more to the IRS and send you a copy of this report. Find out more by reading our tax guide.
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