How to Avoid Tax on a Savings Account
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Summary:
Generally, you must pay tax on any account that generates interest, such as a savings account. However, the IRS has several programs that either mitigate or eliminate tax if the money is deposited in a special savings account. Investing in an account that will be used for medical expenses, educational expenses, or retirement can help significantly alleviate the tax burden on the interest income from a savings account.
Most people interested in opening a bank account are offered two options: a checking account and a savings account. A checking account is typically used as a transactional account for daily expenditures. A savings account, on the other hand, is where money is squirreled away to be used for a future purpose, such as a down payment on a home or a child’s education.
Savings accounts will typically bear interest in one form or another. Now comes the real question: Is the interest that is being generated by money in a savings account taxable?
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Is savings account interest considered taxable income?
The short answer is yes, absolutely. Any money you gain — whether it be income, investment gains, dividends, or estate transfers — is subject to tax by the IRS.
However, the government has created several programs over the past several decades to encourage people to save for certain goals by offering tax incentives or tax-free savings accounts. If the money is geared toward certain kinds of expenses — such as educational expenses, medical expenses, and retirement — then there are specific programs and structures that the IRS offers to help with tax.
You might already be familiar with such plans as a 529 education plan, a Roth 401k, and a health savings account (HSA). These are examples of plans that allow you to save for certain purposes that are encouraged by the government. If you have no need to save toward any of these goals, then municipal bonds are another option for you to save your money with tax advantages and very low risk.
Traditional savings account
If you have a standard savings account with your bank, then you should be receiving interest on that money, whether or not it’s considered a high-yield savings account. The IRS stipulates that the interest earned on money in a savings account will be taxed as normal income.
In the United States, the federal income tax brackets span from 10% to 37%. Any additional income that you have derived from your savings will be taken into consideration to determine your income bracket.
How savings interest affects your tax bracket
Imagine a researcher named Carlos who works in the academic field and makes $80,000 a year. Carlos’s father died five years ago and left him a significant amount of money. As he wasn’t sure where to invest all that inheritance at the time of his father’s death, he simply put the money in a standard savings account at his bank. As a result, he gains an additional $50,000 a year in interest income from the money in that savings account.
The tables below show how the IRS taxes individual filers progressively as of 2021 and how Carlos’s tax burden is affected by factoring the interest from his savings account into his income.
| Without Interest | With Interest | |
|---|---|---|
| Income | $80,000 | $120,000 |
| Standard Deduction | -$12,550 | -$12,550 |
| Net Taxable Income | $67,450 | $107,450 |
| Tax Due | $10,587 | $19,809 |
| Effective Tax Rate | 15.70% | 18.40% |
You can use the tax rate table below to calculate the impact of savings interest in your case.
As interest on standard savings accounts is taxed as normal income, it also affects an individual’s tax bracket. Had Carlos not set his inheritance aside in a savings account, he would only have had to pay taxes on his earnings up to 22% because his taxable income wouldn’t exceed the limit of $86,375. When calculating his earned income tax rate with the savings account interest, however, his taxable income moves up a tax bracket and is now taxed at 24%.
This example only illustrates a scenario in which Carlos sets aside his inheritance in a standard savings account at a traditional bank. Were he to save that money in a tax-exempt account, however, he would be able to save significantly more on his tax bill.
Savings accounts with tax advantages
Although a standard savings account doesn’t provide any tax advantages, that doesn’t mean you can’t find savings accounts that do. The IRS seeks to encourage investment for specific purposes by offering special tax-exempt accounts. A tax-free savings account will typically fall into one of three categories: education, medical, and retirement.
Educational savings plans
529 plans
529 plans are investment accounts that offer tax advantages to encourage saving toward educational expenses. College tuition, room and board at a university, and even K-12 private school tuitions all fall under this classification.
Similar to how a Roth IRA works, the money that you contribute to a 529 plan is considered after-tax dollars, meaning the total amount is taxed before your contribution, just as if you were saving in a normal savings account. However, the money in the account can grow, generate income, and be withdrawn tax-free as long as it’s spent on what the IRS considers “qualified education expenses.”
Coverdell savings accounts
A Coverdell savings account, or Coverdell ESA, works similarly to a 529 plan in that you can withdraw from it tax-free if the money is used for qualified education expenses. The main difference revolves around K-12 expenses and tuition. A 529 plas will only cover K-12 tuition, whereas a Coverdell plan will cover both tuition and expenses. Furthermore, once the beneficiary surpasses age 30, any money left in a Coverdell plan will be taxed, while a 529 plan does not have any limits or regulations regarding age.
Retirement plans
Individual retirement accounts (IRAs)
An individual retirement account, or traditional IRA, lets you deduct money on the front end when you pay income tax. For instance, continuing from the previous example, if Carlos had contributed $20,000 of his $120,000 in taxable income to a traditional IRA, then he could deduct that $20,000 from his income tax, leaving him with a net taxable income of $87,450 based on the following formula:
Net taxable income after IRA contribution
$120,000 (income plus interest) – $12,550 (standard deduction) – $20,000 (IRA contribution) = $87,450
A traditional IRA offers tax-free growth, meaning you don’t have to pay taxes on the interest while the money is in the account. However, whenever you take money out of a traditional IRA, both the initial capital as well as the interest earned will be taxed at the normal rate. In essence, traditional IRAs are not taxed at source (before contribution) but are taxed upon withdrawal.
Roth IRAs
Roth IRAs are similar to 529 plans in that they are taxed at source but are allowed to grow tax-free and be withdrawn tax-free. This means that if Carlos were to put that $20,000 into a Roth IRA instead of a traditional IRA, he’d be taxed the same as if he’d kept the total $120,000, but that money would be allowed to grow and be withdrawn completely tax-free.
401k plans
401ks are a great way for employees to save for retirement by contributing part of their wages to an investment account, often with the help of their employers. Many companies offer a match program for their employees’ 401ks, meaning the employer agrees to match any amount that an employee contributes.
Traditional 401ks behave like traditional IRAs in that you are not taxed for the money you deposit or the interest you earn while the money stays in the account, but you are taxed on the principal investment plus any interest earnings when you withdraw.
Roth 401ks
Like a Roth IRA, deposits in Roth 401ks are taxed at source; however, any principal and interest earned from a Roth 401k savings account is not taxed upon withdrawal. This is particularly advantageous for individuals in a low-income tax bracket, as any taxes incurred upon deposit might be minimal compared to the taxes that would be avoided when withdrawing. However, on the flip side, individuals with a huge income tax burden might prefer a traditional 401k, as they might prefer to save taxes at source rather than later down the road.
403b plans
403b plans are special retirement plans that are typically reserved for public school employees and other government-related public sector employees in tax-exempt organizations, such as nurses and doctors. These plans act as traditional 401ks in that they are not taxed at source but taxed upon withdrawal.
457 plans
457 plans are similar to traditional 401ks and 403bs as they are also not taxed at source, thus providing relief from higher progressive income taxes. These plans are primarily used for nonprofit organizations and certain government employees.
Pro Tip
Many of these tax-exempt savings plans, whether for education or retirement, will have annual contribution limits. Make sure you know how much you can contribute to a tax-free savings account every year so you can plan your deposits accordingly.
Health care savings plans
Yes, it’s no secret that the United States has the highest health care costs of any developed country in the world. That’s why the government seeks to mitigate these high costs by offering tax-free savings plans specifically for medical expenses. The main health care savings plans offered by the IRA are HSAs and FSAs.
Health savings accounts (HSAs)
A health savings account, or HSA, can be opened by any individual living in the United States, regardless of whether they are working for an employer, self-employed, or unemployed.
Health savings accounts combine the best features of both traditional and Roth savings plans. HSAs are not taxed at source (same as a traditional plan), nor are they taxed on withdrawal (same as a Roth plan), as long as the funds are allocated toward what the IRS considers “qualified medical expenses.”
However, health savings accounts can only be used for high-deductible insurance plans. As of 2022, a high deductible health plan costs $1,400 per year for an individual and $2,800 for a family.
Flexible spending accounts (FSAs)
A flexible spending account, or FSA, works similarly to a health savings account, but with three important differences. For one, the plan must be sponsored by an employer. An FSA doesn’t require a high-deductible insurance plan, and it can be used for child care on top of the usual medical expenses approved by the IRS. FSA distributions are not taxed at source and can be withdrawn tax-free, assuming they are used for qualified medical expenses.
Government bonds
Maybe you don’t have any plans to go back to school (or to help someone else in your family get an education). Maybe you have comprehensive health insurance that covers every possible medical expense with no deductible. And maybe you finished saving for retirement a long time ago and don’t need to worry about making ends meet when you’re done working. But you’re still human, and like everyone else in the world, you hate paying taxes with a passion.
If you still don’t want to owe taxes any more than you absolutely have to, government bonds may be your best bet. (Treasury bonds will allow you to avoid state income tax and local tax, but you would still be on the hook for federal income taxes, which is currently our main focus.)
There are two types of government bonds that allow you to avoid federal income taxes: municipal bonds and private activity bonds.
Municipal bonds
Municipal bonds are bonds sold by municipalities to fund local government projects such as dams, roads, and high-speed trains. Although they do not offer the highest interest rates, municipal bonds will not be subject to tax by the federal government. In fact, most states and some localities will not tax these bonds either.
Private activity bonds
Private activity bonds are municipal bonds that are used to raise money for private projects rather than public works. These are also exempt from regular federal income taxes, but they might be taxed under the alternative minimum tax system. Private universities and affordable housing are examples of projects that would offer private activity bonds.
FAQ
Do I have to pay taxes on my savings account?
Yes, you must pay taxes on any interest income earned from a traditional savings account. However, if you use a special tax-exempt savings account or savings plan, the Internal Revenue Service will give you a tax break on that money.
How much money can you hold in a savings account before being taxed?
As much as you want. You are only taxed based on the interest income earned on the savings, not the total amount of savings in your account.
Where should I be putting money to avoid taxes?
To avoid taxes, you can put your money in a special tax-free account, like a Roth 401k or an HSA.
How much money should I keep in a savings account?
However much you feel comfortable saving. However, be aware that you will get a tax bill based on how much interest you earn on those savings.
Key Takeaways
- Any interest earned on traditional savings accounts is considered taxable income.
- The IRS offers tax-advantaged savings accounts in which individuals can deposit money for medical, educational, or retirement purposes.
- Traditional 401ks, Roth 401ks, 529 plans, and HSAs are examples of savings accounts that enable you to save on taxes.
- Government bonds, such as municipal bonds and private activity bonds, are an ideal option if you want to save on taxes but don’t have a specific medical, educational, or retirement goal to save toward.
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