Could Rising Savings Account Rates Leave You With a Nasty Tax Surprise?

Don't get caught off guard.

If you have money you're not planning to use for a long time, then a savings account may not be the best place for it. That's because you'll only earn a limited amount of interest by keeping your cash in savings, whereas if you invest it in a brokerage account, it might grow into a much larger sum.

But the money you have designated as your emergency fund should absolutely hang out in your savings account. So should any funds you might need within the next few years, such as money you're socking away to put down on a home purchase.

Meanwhile, if you're tired of earning minimal interest in your savings account, here's a bit of good news. The Federal Reserve is moving forward with a series of planned interest rate hikes. As that happens, savings accounts should start to pay more generously. But while that's clearly a good thing, it could result in a tax consequence you may not be prepared for.

Your money isn't all yours to keep

Just as you're required to pay taxes on the income you earn at your main job or side hustle, so too does the IRS get a piece of the interest income you collect from your bank. And now that savings account rates are poised to rise, you could end up owing the IRS more by virtue of collecting more interest.

Is that a reason to pull your money out of a savings account? Absolutely not. Unless you really have a lot of money in savings, chances are, your interest income won't trigger an unmanageable IRS bill. But you should still expect to see your tax liability increase if your interest payments do the same.

Interest income is actually taxed the same way as ordinary income. That means it's taxed at the highest rate you're subject to.

Remember, U.S. taxes operate on a marginal basis so you pay a lower rate of tax on your lowest dollars of earnings and a higher rate on your highest dollars of earnings. And so if your savings account's interest rate rises and you have a decent balance, you should prepare to pay more money to the IRS. That could mean writing out a larger check or getting a smaller refund during tax season.

Are rising interest rates a good thing?

Rising savings account rates are a good thing, as that means you'll earn more money on the cash you have tucked away in the bank. But rising credit card interest rates, for example, are a bad thing. If you're carrying a balance, it could start costing you more.

Unfortunately, when consumer interest rates rise, they often do so for better and for worse at the same time. And so in the coming months, we could see savings accounts start to pay more interest, but we could also see consumer spending shrink as borrowing gets more expensive. That could, in turn, lead to a recession, so it's something we'll need to keep an eye on.