On top of investing and saving for your retirement, it is also a good idea to have three to six months’ worth of expenses saved up in case of an emergency in a high-interest savings account. This money will be easily accessible to you in case you run into any problems in the near future with the added benefit of giving you peace of mind.
However, even with a high-interest savings account, the amount of money you earn in interest will be pretty small. Did you know that the IRS considers the money you earn in interest in your savings accounts to be a source of income? This means that you are likely getting taxed for the money you earn from your savings accounts. Continue reading to learn more.
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IRS Tax Guidelines for Savings
When filing for your yearly taxes, the IRS expects you to report any income you brought in that year. Many people don’t realize that their reported income includes any interest they may earn from the various savings accounts that they have. You will typically receive a 1099-INT tax form in the mail for income earned, but you are still expected to report that income whether you receive the form or not.
So, it is important to know exactly what you need to report to the IRS when tax season comes around. Any interest you earn from savings will be added to your earned and other taxable income and included in your adjusted gross income.
Examples of Taxable Interest
Generally, the interest you earn from your savings accounts is considered taxable income by the IRS. However, there are some exceptions to that. Here is a general overview of what the IRS considers taxable income:
- Interest from most bank accounts: Any interest that you earn from a savings account, CD or money market account is considered taxable income.
- Interest from Treasury bills: If you earn interest on a Treasury bill, note or bond, you’ll have to pay federal taxes on this income. However, it’s exempt from state and local taxes.
- Interest from savings bonds: Any interest you earn from Series EE and Series I savings bonds are excluded. But other than that, you’ll have to pay taxes on interest earned on savings bonds.
- Additional interest: If you receive $600 or more in income from a business, you should receive a 1099-INT form in the mail. You’re responsible for paying taxes on that income.
How Different Types of Income Are Taxed
When it does become time to report your taxes, there are two different types of income you can report called earned and unearned income. Here is what each of them mean:
- Earned income: This is the money you make in exchange for doing work, either in your business or at a job. This includes the money you’re paid in wages, and also includes things like travel or meal reimbursements.
- Unearned income: Unearned income is money you make without performing a professional service. Interest, dividends, and financial gifts are all examples of unearned income. Or if you receive Social Security, unemployment, or retirement distributions, those are also examples of unearned income.
Although these may sound simple enough, it is important to understand the difference. If your forget to label something or do so incorrectly, it can cause some issues for you when tax season comes around.
You will pay three different types of taxes on earned income: payroll taxes, state income taxes and federal income taxes. If you have a full-time job, then your employer takes these taxes out before you receive your paycheck. However, you will not have to pay payroll taxes on unearned income. Instead, yo will just pay income taxes based on the tax bracket you fell in for the year.
How Much Will I Have To Pay in Taxes?
The amount that you will have to pay will depend on your total taxable income for the year and your current tax filing status. Here are the marginal tax brackets for the income year:
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Are There Tax-Free Savings Accounts?
After going through our guide, you probably understand now that you must pay taxes on the interest you earn from your savings. But now you’re probably wondering if there are tax-free savings accounts. The answer to that question is yes. You will receive certain tax advantages by saving your money in an individual retirement account. Let’s take a look at the ones you should consider.
An IRA savings account combines the features of a traditional savings account with an IRA. You’ll earn interest on your account, but the money is tax-deferred, which means you can let your money grow tax-free until retirement.
The only negative worth mentioning about this type of account is that there are contributions limits on an IRA savings account. You can contribute a maximum of $6,000 a year, plus an annual catch-up contribution of $1,000 if you’re over the age of 50.
With a traditional IRA, you’ll have to pay taxes on the money you save once you reach retirement age. The advantage to this is that you don’t have to pay upfront taxes, but you will have to pay taxes once you retire.
When you open a Roth IRA, however, you’ll fund the account with after-tax dollars. This means that when you reach retirement, you can withdraw tax-free earnings, which can be a big advantage if you expect to be in a higher tax bracket later in life.
Once you have earned money in interest from savings this year, you are responsible for reporting that income to the IRS. Even if your earnings seem small now, you could face fines and penalties if you fail to report all of your earned and unearned income. An accountant would be extremely helpful for guiding you through this process and the tax season. For more posts like this, check out our list of the best bank rates.