Do You Pay Taxes on a High-Yield Savings Account?

High-yield savings accounts have become the no-brainer strategy for large portions of the investor class, for an assortment of compelling reasons. But keep a rein on your enthusiasm for this financial tool: Uncle Sam will want his cut.

That’s right. Under most circumstances, those lovely, high-yield deposits are taxable.

But there’s taxable, and there’s paying taxes. Whether your account will get hammered depends on a variety of circumstances, including the account’s yield, the saver’s tax bracket, and applicable tax laws.

Concerns about taxation do not mean you should avoid high-yield savings accounts. At a heady 5% or more, returns are running nearly two points ahead of springtime inflation. Compare that to the crummy 0.46% banks are paying on the average savings account, according to the Federal Deposit Insurance Corp.

And, up to FDIC limits, your principle is 100% guaranteed against loss. Try that with one of those heart-stopping crypto-currency exchange-traded funds.

This high-yield bonanza is not without its downsides, however. Withdrawals may be limited, for instance. Minimum balances may apply. Also, rates can fluctuate, so you should check in from time to time to make sure your high-yield savings account is, indeed, high yield.

“High-yield savings accounts are great ways to grow your money quicker than traditional savings accounts,” says Scott Lieberman, founder of TouchdownMoney.com. “However, not all accounts are created equally.”

Lieberman cautions about fees, minimum balances, penalties for frequent withdrawals, and downshifting interest rates.

“With high-yield accounts, you always need to read the fine print,” he says.

Also, did we mention those earnings are taxable? Well, they are.

Understanding High-Yield Savings Accounts

High-yield savings accounts (HYSA), offered by financial institutions across the spectrum, are deposit accounts that pack an annual percentage yield (APY) that is usually a multiple of the national average APY on a traditional savings account.

“High-yield savings accounts are simply savings accounts that offer a higher interest rate compared to regular savings accounts,” says Michael Ashley, a personal finance consultant at Richiest.com. “They’re gaining attention because they provide an opportunity for individuals to earn more on their savings without taking on significant risks.

“With interest rates on the rise, most people are increasingly turning to high-yield savings accounts to maximize the return on their cash holdings while still maintaining liquidity and safety.”

Do you like rewards without much risk? You’re talking Crystal Stranger’s language. Stranger, whose credentials include Senior Tax Director and CEO of OpticTax.com, appreciates the allure of HYSAs.

“When savings accounts are yielding over 5% it seems like a no-brainer to be putting money into these assets rather than other investments with greater risk but marginally similar rewards,” Stranger says.

Recently pitched a real estate syndicate deal with a meager 3.5% cash-on-cash return, and concerned about a risk of loss, Stranger says she’s delighted with her ironclad HYSAs that are earning nearly 5.5% guaranteed.

If you’re saving for a specific, time-limited purpose — an emergency fund, the downpayment on a house or car, a grand vacation, a lavish Christmas, hacking away at debt — a high-yield savings account may be just the thing. Or, if you’re saving for several time-limited ambitions at once, assorted high-yield savings accounts may suit you. Many banks will allow you to open several HYSAs and give them names (Emergency Fund, Christmas Club, Lamborghini Fund, Eliminate Debt Plan) that reflect their purpose.

Also, because your checking account probably isn’t paying a dime in interest, HYSAs are also an excellent place to stash cash. Just be mindful of the withdrawal or transfer restrictions.

Some brick-and-mortar financial institutions are in on the HYSA game, but the best returns tend to be offered by online banks such as Betterment, SoFi, Bask Bank, CIT Bank, NewTek, Western Alliance, and Synchrony.

As noted above, rates on HYSAs fluctuate, influenced by national and world economic events and conditions, as well as Federal Reserve policies.

Comparing High-Yield Savings Accounts to Other Savings Options

From traditional and high-yield savings accounts, certificates of deposit, and money market accounts, banks — whether traditional, commercial, or online — and credit unions offer a variety of places to park cash safely.

The choice(s) best for you depends on your circumstances and goals.

Traditional savings accounts are the least complicated. Savers’ deposits are insured up to the FDIC limit ($250,000) and can be accessed 24/7 without limitations on withdrawals or transfers. For this convenience, financial institutions pay piddling interest rates, usually less than 0.5%.

You’ve met high-yield savings accounts, so we’ll move on to CDs and money market accounts.

Unlike HYSAs, whose interest rates fluctuate with outside forces, CDs pay a competitive fixed rate on a specific amount of money for a specific amount of time. Buy a $10,000 CD paying 5.25% APY for two years, and no matter what the Fed does or who’s in the White House or which country won the World Cup, at the end of the term, you’ll earn $1,050 and now have a total of $11,050. Roll it over at the new prevailing rate and it will keep right on earning.

The catch: The guaranteed return is linked to a heavy penalty if you cash out even a portion of the CD early. Terms vary, so make sure to pin down the penalty clause before buying any CD.

Money market accounts (MMAs) offer returns that are competitive with, and sometimes superior to, HYSAs. Also, like other bank deposits, MMAs are protected by FDIC up to $250,000. And they are fabulously liquid; some MMAs include debit/ATM access and check-writing privileges.

The downside: MMAs often require a substantial minimum deposit and may come with monthly fees. Shop around. Your mileage may vary.

How Interest on Savings Is Taxed

The buzz about high-yield savings accounts may be new, but taxes on savings earnings are anything but new. Interest earned on any sort of savings vehicle is considered regular income reportable to the IRS. Depending on a wide variety of other factors in your financial life, you may wind up owing taxes on savings interest.

“In simple terms,” says Richiest’s Ashley, “the money you earn from a high-yield savings account is usually taxed just like your regular income.

“This means that the interest you make on these accounts gets taxed by the federal government and, depending on where you live, your state government too.”

Savers should receive a form 1099-INT from their banks or credit unions for every account that earned more than $10 in the previous calendar year. Do not stuff these in a drawer and forget them. The IRS looks dimly on taxpayers who fail to fully report their income.

The Tax Implications

Unlike income earned as an employee, savings interest income is not subject to withholding. Instead, its full impact on your return is realized when your taxes are filed.

What’s that? You say you didn’t touch your interest payments; you left them in the accounts they were paid into? Doesn’t matter. Unlike tax-deferred accounts such as your 401(k) or IRA, interest earned on HYSAs is taxable in the year it was paid.

How much you owe on your paid interest hinges on Line 15 of your Form 1040, taxable income. That’s the figure that determines your marginal tax rate. The higher your taxable income, the more you’ll owe on your interest income.

All this taxpaying business is not a one-way street, however. The IRS code provides opportunities for mitigating and minimizing your tax liability. Among these strategies are:

• Max out your retirement accounts and employee benefits. The more you can stash in a 401(k) plan (up to $23,000 — more if you’re 50 or older) or a traditional IRA (individual retirement account), the lower your taxable income becomes.
• Use a health savings account (HSA) to pay qualified medical expenses.
• Start a business or a side hustle. Turn a hobby, passion, or your particular expertise into a profit-seeking consultancy, for instance. Besides developing an additional stream of household income, you could reap deductions for using a home office and a wide variety of other costs (including depreciation of major investments) involved in the set up and maintenance of your enterprise.
• Claim tax credits, such as the Child Tax Credit (youngsters younger than 17 who lived with you more than half the year) which come directly off your tax bill, dollar for dollar.

How to Report Interest Income on Your Taxes

Reporting interest on your taxes involves little more than addition and entering the total on the correct line on the correct form.

“Interest earned from [HYSAs] is counted as ordinary, taxable income by the IRS,” says Jonathan Feniak, General Counsel at Denver-based LLC Attorney. “Essentially, a 1099-INT form is issued by banks for interest earned over $10 and this needs to be reported on your federal tax return. All being said, the tax impact may vary based on one’s taxable income bracket and the total interest earned.”

Most taxpayers will total the interest reported on their 1099-INT slips and record it on Schedule 1 of Form 1040.

Savers whose total interest income topped $1,500 — congratulations, by the way — report their earnings on Schedule B of Form 1040.

Calculating Taxes on Your High-Yield Savings Account

The United States uses a progressive federal income tax system. The higher a taxpayer’s income, the more she, he, or — for those filing jointly — they pay(s). For 2023-2024, the seven federal income tax brackets range from 10% for the lowest income levels to 37% for the highest.

A taxpayer’s marginal rate refers to the percentage paid on the last dollar of reported income. A married couple filing jointly reporting $125,000 in taxable income, have a marginal rate of 22%. The couple’s effective tax rate, however, would be a combination of their earnings in the 10% (up to $22,000), 12% ($22,000 to $89,450), and 22% ($89,450 to $190,750) brackets.

Assuming they didn’t have adjustments below the taxable income line, such as child tax credits, their tax bill would be a little more than $18,000, for an effective tax rate of 14.4%. However, because it would be stacked atop their employment earnings, their HYSA income would be taxed at the marginal rate of 22%.

Wait, there’s more. Because personal income taxes are designed as a pay-as-you-go system, some earners may need to make quarterly estimated tax payments. That’s certainly the case for contractors, side-hustlers, freelancers, and others who earn money as something other than regular employees. If their interest earnings are high enough, the same caution would apply to savers.

Tax Deduction Opportunities Related to Saving

Taxpayers who are also workplace earners (whether employees, contractors, or freelancers) have a variety of opportunities to mitigate the impact of high-yield savings accounts.

Assorted tax-advantaged retirement accounts spring to mind, including company-sponsored plans such as 401(k) (for private-sector employers), 457 (for government and nonprofit employers) and 403(b) (for certain public school employees and tax-exempt organizations).

There is no way to alleviate or mitigate taxes owed on HYSAs themselves, notes Reagan Smith, Associate Financial Planner at Seattle-based Millennial Wealth LLC.

“However, there are other accounts you can use to reduce ordinary income tax,” Smith says. “Accounts that can reduce taxable income are pre-tax 401(k)s, deductible IRA contributions, HSA contributions, dependent care FSA, or any other ‘pre-tax’ accounts.

“These accounts reduce the amount of income you are taxed on which can lower your tax bracket, save you from a large tax bill, and are overall the best way for long-term saving. Unlike a high-yield savings account, these are invested in the market which can be riskier.”

Looking ahead to Tax Year 2024, employees can stash up to $23,000 in 401(k) and similar plans; employees 50 and older can contribute an additional $7,000. Those limits can defer a whole lot of HYSA interest.

Individual retirement accounts (IRAs) are available to virtually all who work for an income, but they are a favorite of people who work for themselves and receive 1099 forms. That limit in 2024 is $7,000; proprietors, freelancers, side-hustlers and other 1099 warriors older than 50 are allowed to sock away an additional $1,000.

Maximizing Your Savings While Managing Taxes

There’s a delicate balance between maximizing returns on your savings while efficiently managing your tax liabilities. Professionals spend years in school, then study to become licensed in their craft; maintaining that license requires continuing education.

All of which is to say, what is outlined here is exactly that: an outline. Designing a plan that best suits your particular situation may require consulting a financial planner or investment professional.

“There is a lot of math you can do about rates of return, taxes due on high-interest savings accounts and other factors — and it’s generally advisable to consider the numbers carefully,” says David Straughan, MarketWatch Guides Personal Finance Writer and Researcher.

“However, it is important to listen to your gut! At least some of your decisions should be made around what makes you feel most comfortable. If you may need access to that money at some point, such as for an emergency or for a major purchase like a home or a car, a high-yield savings account can give you that flexibility.

“If that’s not a concern for you and your savings plan is for the long-term, other, more tax-advantaged savings accounts may be a better option.”

Indeed. We mentioned tax-advantaged retirement accounts above. Most retirement accounts provide a range of options based on the investor’s goals, risk-tolerance, and nearness to retirement. An employee in his/her 30s almost certainly has a financial mindset different from a contractor/freelancer nearing 65.

But whether you’re feeding a tax-deferred retirement account or saving/investing for more immediate goals, the most important ingredient is consistency: If it’s growth you want, pad your accounts every pay period. Whether you’re putting money into the stock market or simply adding to a high-interest savings account, no money strategy beats steadiness over time, what investment professionals call dollar-cost averaging.

Experts customarily encourage spreading around your investments and savings among a variety of proven strategies: Individual stocks, mutual funds, bonds (including municipal bonds, whose earnings usually are tax-free), real estate, precious metals, and cash savings.

“Instead of HYSAs, one could invest in municipal bonds or U.S. treasury bonds,” says Christian Putnam, a Washington, D.C., CPA, and owner of Augur CPA. “These securities often pay similar interest rates, but the income isn’t taxable.

“Having a good mix of HYSAs and government debt will help offset your tax liability. Another option is to look for stocks that pay dividend rates similar to HYSAs. Dividends from stocks held more than one year are taxed at lower rates, so in the long term, the tax burden might be less.”

Whatever your scheme, add funds across the board with a steady-as-she-goes plan and your portfolio should reap the benefits of growth, reinvested dividends, and the wonder of compound interest: That is, interest payments earning interest of their own.

Consider: $1,000 parked in a high-yield savings account for five years at a 5% APY will be worth $1,276.28, or somewhat more than $50 (the first year’s yield) multiplied by five. Left to itself for 40 years, and assuming an ongoing 5% yield, that initial $1,000 deposit would grow, thanks to compounding, to $7,040, substantially more than $50 multiplied by 40.

Legal Considerations and Compliance

There’s clearly plenty to love about HYSAs. But before you commit a substantial amount of your dearly earned money, understand the legal considerations and compliance requirements for opening and maintaining a HYSA.

Make certain your deposits will be backed by the Federal Deposit Insurance Corp. The FDIC is a government guarantee that your funds are safe and secured up to the federal limit of $250,000.

Be alert, also, to potential restrictions on access to your money. Some institutions offering HYSAs may limit the number of withdrawals or transfers allowed in a given period of time. You also may be required to make a substantial opening deposit and maintain a certain balance to preserve your high interest rate.

Then there’s the application process. Applicants with checkered banking histories — unpaid bank fees and/or bounced checks are red flags — may fail to qualify for HYSAs.

Balancing Growth and Tax Responsibilities

In a perfect world organized by money nerds, savings yields always would be astronomical and taxes always would be zero. And our debts would be settled at the end of every month. As long as that nirvana eludes us, it’s useful to keep in mind the balance between high returns and tax implications.

Your particular circumstances may merit a consultation, and even an ongoing relationship, with a financial advisor and/or licensed tax professional.

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