Why This 'Tax Problem' With Savings Accounts Isn't Really a Problem -- and How to Avoid It

During the past few years of rising interest rates, high-yield savings accounts, CDs, and other interest-earning accounts have started paying higher APYs. And that's a good thing for your savings: earning higher yield is always better than leaving your cash in a near-0% APY account.

But one slight downside of higher interest is that you have to pay taxes on it. The interest earnings on your savings account (or other accounts) are not "free money" -- they're taxable interest. Your bank will send you a 1099-INT form for you to report your interest income when you file your tax return.

Let's look at a few reasons why you might get hit with a surprise tax bill because of higher-than-usual interest income from your savings account -- and what to do about it.

Interest income tax is based on your marginal tax rate

Interest income is taxed as "ordinary income," meaning that the IRS treats this money the same as if it was income from your job. But unlike your paychecks where you withhold tax every month, taxable interest income can come as a surprise at tax time. You might have a few hundred dollars or thousands of dollars of extra income that you hadn't planned for.

Your savings account taxable interest will be taxed at your marginal tax rate (aka: your tax bracket). So if you had $10,000 in a high-yield savings account that earned 5.00% APY for all of 2023, that means you will have about $500 of taxable interest income. If you're in the 22% tax bracket, you'll owe about $110. That means you only get to keep $390 of your savings account earnings after taxes.

How to avoid tax on savings account interest

Is having a high-yield savings account still worth it if you have to pay so much tax on the interest? It depends on your personal finances and your tax bracket. Why are you keeping that cash in the bank? If it's your emergency savings fund, just leave it alone and keep paying tax on the interest. A high-yield savings account is usually the best place to keep your emergency fund, because it's easy to withdraw money when you need it, and you can still earn a higher yield than some of the best CDs.

But if you already have a healthy three to six months of emergency expenses saved up, and you're in a higher tax bracket (like 22% or 24% or higher), you might be keeping "too much" cash in the bank. This is a good problem to have, but it's still a problem.

Too much cash in the bank could mean that you're not investing in the most appropriate way for your long-term financial goals. You could also be paying too high of a tax rate on your interest income, when you could minimize your tax bill with a few smart tax-planning strategies. Here are a few ideas to reduce the tax impacts of savings account interest.

1. Max out your 401(k)

Tired of paying taxes on savings account interest? Counteract that extra income by reducing your income in other ways -- by maxing out your 401(k). The 401(k) is especially useful for higher-income employees, because there are no income limits on who can use it. And you can put $23,000 into your 401(k) for 2024 -- and an extra $7,500 catch-up contribution if you're age 50 and over.

2. Contribute to a tax-deductible IRA or health savings account

If you qualify for a tax-deductible IRA (there are some limits based on income, and on whether you or your spouse is covered by an employer retirement plan), you can use this as a great way to reduce your income for tax purposes. You can put up to $7,000 into a traditional IRA for 2024 (with an extra $1,000 catch-up contribution for the 50-plus cohort).

Do you have a high-deductible health plan (HDHP)? If so, your health insurance will likely make you eligible to use a health savings account (HSA). If you can, you should definitely put money into your HSA! There are no income limits for who can use an HSA; even higher-income people who don't qualify for a traditional IRA can benefit from this useful tax break. Max out your HSA for 2024 with up to $4,150 of contributions for single coverage, or $8,300 for families.

3. Invest for long-term capital gains

Use your taxable brokerage account as an alternative to taxable interest. Instead of paying ordinary income rates on your savings account interest, put your extra cash into investments -- and hold those investments for at least one year. That way, you'll owe long-term capital gains tax -- and for most people, the long-term capital gains tax rate is 15% (or even 0% for some lower-income taxpayers).

Bottom line

If you're paying too much tax on your savings account interest, that's ultimately a pretty good problem to have -- but you always have options to be more tax-efficient with your savings. For people with extra cash savings whose marginal tax rate is higher than 15%, investing your extra cash in a brokerage account for the long term is often a smarter tax move than leaving your cash in the bank.