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By Jamie Smith
While the money you deposit into your savings account is not taxable, the interest generated is usually taxable. The exception to this rule is if you have an IRA or other tax-deferred retirement savings. Your tax status and income determine your marginal tax rate, determining how much you pay on your savings interest.
As you would assume, the Internal Revenue Service (IRS) considers most of the interest you make as taxable income and therefore subject to the Internal Revenue Code. Any income you gain from a traditional or high-rate savings account would appear on Form 1099-INT, shared with you by your financial institution the end of January. This form is different from the more common 1099-MISC form, which shows any miscellaneous income you earned throughout the year from a job or business such as freelancing or a side job.
If you have at least $10 in interest income from your savings account, the Form 1099-INT is important. You are legally required to report any interest income regardless of whether you received the form.
The IRS determines the types of interest income that are subject to taxes. Interest income could come from bank accounts, money market accounts, credit union share accounts and certificates of deposit. Deposited insurance dividends, corporate bonds, savings bonds, and other treasury bills, notes, and bonds are also subject to the Internal Revenue Code. They can be taxable on the interest income generated. Be sure you account for any interest income you get from these sources.
When you open a new account or meet a deposit amount, you may get a cash bonus. This bonus would qualify as taxable income under the Internal Revenue Code.
Referral bonuses for recommending people who eventually open accounts would also be taxable. The same $10 minimum applies for getting a 1099-INT form for the bonuses. Remember this minimum if you get a bonus from your bank or credit union. You will be responsible for paying taxes on it.
The IRS does not lump all types of income together to tax it the same. Instead, the IRS has two general categories to determine the taxable amount, earned income and unearned income. Earned income is what you make from working and includes wages, salary, tips, the net gain for self-employment, benefits from a union strike, some long-term disability benefits and some types of deferred compensation payments.
Unearned income is money paid to you that you did not need to work to earn. This income includes annuity payments, retirement account distributions, pension income, dividends, capital gains from investments, bond interest, revenue produced from rental properties you own, alimony, stock dividends and interest income.
Whether your income qualifies as earned or unearned will determine how the income gets taxed. You pay three different types of taxes for earned income. These taxes include federal income tax, state income tax, and payroll tax, including Social Security taxes and Medicare taxes. Your employer deducts taxes on earned income and removes the taxes before giving you a paycheck.
The payroll tax does not apply to unearned income, and typically you pay your standard federal and state income rate. Your taxable income for the year determines your unearned income tax rate. For example, if you fall in the 25% tax bracket, all interest income from your savings gets taxed at 25%.
The Internal Revenue Code ensures the citizens of the United States pay their fair share of taxes. As far as the federal government is concerned, income is income, independent of the source. Any income of any type is almost always taxable.
A benefit of paying taxes on savings interest is that you don't have to pay the tax quarterly, as you do with other income sources. If you have a side job or are self-employed, you must pay estimated taxes every three months. And self-employment carries a self-employment tax. The IRS can penalize you for failure to pay or underpay quarterly taxes.
Failure to report any or all of your interest income can result in significant penalties for the year. Even if you think the amount is too small, it is better to be safe than sorry and report the interest income you made. If the IRS discovers you've neglected to include some of the interest on your tax return, you will be responsible for the remainder owed plus penalties.
Even a small amount of unclaimed interest can cause a big headache, so report it all.
One type is an IRA savings account that blends some of the features of a savings account with an Individual Retirement Account. This account is taxable at withdrawal time, not when you've made deposits or accrued interest. Early withdrawals may carry some deposit limits and penalties, so make sure you understand the ins and outs before starting an IRA savings account.
You may be aware of a tax-exempt retirement account called a Roth IRA. With a Roth IRA, you pay the tax on the front end, meaning your contributions to a Roth IRA come from after-tax dollars. When the Roth IRA matures and you reach the proper age, you'll be free from paying taxes on the interest and when you withdraw the money.
Even though you understand that you will need to pay taxes on the interest made in your savings account, this reality should not deter you from establishing an emergency fund or setting aside money for whatever may interest you. Instead, use this knowledge to motivate you to find an account that will give you a great savings rate. Do not forget to include fees in your comparison.
Check out how much interest you can earn with an Alliant High-Rate Savings account.
To learn more about savings accounts, check out these related articles:
While the information provided is based on our understanding of current tax laws, and has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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