When you file your income tax return at the end of each financial year, you’ll need to declare all of your sources of income, including your salary and income earned from investments. This includes declaring any interest you’ve earned from deposits in savings accounts.
But at what rate is the interest taxed and how can you get the best possible investment returns from a savings account? Read on to find out.
You won’t need to pay tax on the amount you deposit into your account because you’ve already paid income tax on it. However, any interest accrued on your deposit is considered ordinary income and is subject to taxation during the same year that you receive it. It will be taxed at the marginal rate, which is the same rate you pay on your income.
What is ordinary income?
Ordinary income is income that is gained from sources other than capital gains. This includes:
- Other types of compensation from employment
- Net income from a sole proprietorship, partnership or LLC
- Deductions, depreciation or depletion allowances
- Gambling winnings
The amount of tax that applies to the interest you earn on your savings account will be determined by your overall taxable income. The total income you earn each year determines the tax rate you must pay, and the IRS tax rates for the 2017-18 financial year are shown below:
|$0 – $9,525||10% or 10 cents for each $1 earned|
|$9,526 – $38,700||12% or 12 cents of each $1 over $9,525|
|$38,701 – $82,500||22% or 22 cents of each $1 over $38,700|
|$82,501 – $157,500||24% or 24 cents of each $1 over $82,500|
|$157,501 – $200,000||32% or 32 cents of each $1 over $157,500|
|$200,001 – $500,000||35% or 35 cents of each $1 over $200,000|
|$500,001 or more||37% or 37 cents of each $1 over $500,000|
For example, if you made $50,000 in 2018, your income falls under three brackets, so you’d owe:
|12%||$38,700 – $9,525= $29,175||$3,501|
Now, say you earned $1,000 in interest on all of your savings accounts in 2018. That increase in income falls into your highest bracket, which is 22%, so you’d pay $220 in taxes on the interest.Back to top
The IRS requires you to declare all forms of income, which also includes interest in various forms:
- Interest from savings accounts and CDs held with banks, credit unions and building societies.
- Interest received from a children’s savings account opened or operated by you.
- Interest paid or credited to you by the IRS.
- Life insurance bonuses (although tax offsets may be available).
- Interest earned from foreign sources (although tax offsets may be available).
The interest you earn can be declared on a 1099-INT form when you file your annual income tax return. Banks and other investment organizations are also required to report the details of the interest they pay to account holders and investors to the IRS. The IRS then verifies the investment income you report with the amount reported by your bank, and if there are any discrepancies, your tax return will be adjusted and fines may apply.
When you open a savings account, your bank may request your TIN. While it’s not mandatory, supplying your TIN is in your own financial best interest – if your bank doesn’t have your TIN, withholding tax may apply to the interest you earn on your account.
If you haven’t given your bank your TIN or if you’re a nonresident of the US, the bank must withhold an amount from the interest you earn and send it straight to the IRS. To avoid withholding tax, you can either supply your TIN when you apply for an account or get in touch with your financial institution at any time to provide it via online banking, over the phone or at your nearest branch.Back to top
There are 43 states that collect income tax. If you live in one of these states, you pay the same tax rate on your savings account interest that you do on earned income.
For example, if you live in California and pay 6% in state income taxes, then you pay 6% on your interest. But if you live in a state like Washington, which doesn’t collect income tax, then you won’t pay anything.
It doesn’t matter where your bank is located. You pay state tax according to the state you live in. So if your bank is based out of Washington but you live in California, you’ll pay California state taxes on your earnings.
The IRS assumes that joint account holders are equal owners of an account and requires them to pay tax accordingly. For example, if you have a joint savings account with your spouse, the interest paid will be divided equally between the two account holders – 50% to the husband, 50% to the wife. Each person will then have to pay tax on 50% of the interest earned.
However, the 1099 form is usually sent to the “first” owner, and because you can’t list more than one name and SSN on it, you’ll need to provide documentation that proves to the IRS that there are multiple owners. The documentation must show the source of the funds, the proportion of contributions from each person, who used the funds in the account and the interest received.Back to top
One common point of confusion for many US taxpayers is the income tax requirements surrounding a child’s savings account. If a parent provides the funds for the child’s account and spends or uses the funds in the account as they wish, the parent must declare interest earned from the account on their own tax return.
However, in some cases the funds in the account will be made up of the child’s own money – for example, the child may deposit money given as a Christmas or birthday present, their pocket money, and funds they earn from a part-time job such as a paper route. If the funds in the account are not used by any person other than the child, the interest earned is classified as the child’s income. If the child’s only source of income is interest totaling less than $1,050 for the financial year, they will not have to file an income tax return.Back to top
- Check interest rates. The rate of interest will obviously play a huge role in determining how quickly you can grow your savings balance. Compare interest rates between accounts to see which ones offer the best deal.
- Watch out for traps. Keep an eye out for some common traps attached to savings accounts. For example, an account may only offer the high interest rate advertised for a limited introductory period, while you may need to satisfy certain criteria (for example deposit a certain amount each month) in order to achieve the maximum rate of interest.
- Look at all the account features. The interest rate isn’t the only factor that affects whether or not a savings account is right for you. Check for hidden fees and charges, whether you are able to access your funds at any time and how you can manage your account.
- Consider inflation. When considering the returns provided by a savings account, remember to take into account inflation as well as the tax you need to pay on interest. Factoring in the effects of inflation increases the overall effective tax rate on your savings balance, so it’s important to shop around for an account with a high rate of interest.
- Compare your options. With so many institutions and products available, it’s important to compare your options to find one that suits your financial needs. Start comparing a range of accounts today, or see our lists of the best savings accounts by specific features.
- Ask your accountant for help. For any advice on savings account interest and how it will affect your income tax return, ask your accountant or financial adviser for expert assistance.
How to pay taxes on CD interest
Just like any other type of income you earn, you’ll need to pay tax on the interest you receive from savings accounts. However, the amount of tax you’ll pay depends on your annual income, the way your account is set up and when your interest is paid. Compare your options to find a savings account that suits your needs, then speak with your accountant for more details on how savings account interest will affect your income tax return.