We all have something to save for. Whether it’s that next big holiday, a hefty house deposit, or an emergency rainy day fund, it’s always a good time to stash the cash and prepare for the future.
Whatever your motivation, you’ll probably have the same end goal – building a comfy financial cushion to fall back on. Unfortunately, a few factors can get in the way, including a tax on savings accounts.
If you’re trying to grow your savings, you’ll want to avoid paying as much tax as possible on your earnings.
So, to set you up for success, we’ve put together some of our must-know tips to help you avoid tax on your savings account. It’s not as tough as you might think, and we’re here to show you how to do it…
Is There Tax On A Savings Account?
The bad news is that all eligible taxpayers will need to pay tax on the interest their savings accounts earn. If this is you, the good news is that you WON’T have to pay tax on the primary amount.
So, if you put $1000 into savings, you won’t pay tax on that amount, just the interest it accumulates.
This is because the interest you accumulate on your savings is considered additional income; therefore, it will be taxed at your regular income tax rate.
Interest Tax: How Is It Calculated?
So, your nest egg is starting to accumulate a little interest, which means it’ll be taxed soon enough. But how is a tax on your interest calculated?
Well, any interest you earn from your savings account will be taxed in conjunction with your yearly tax rate.
In other words, the amount of tax you owe will be calculated according to your total taxable income, your current tax bracket, and how much money you’ve earned in interest.
According to the Internal Revenue Service (IRS), tax inflation adjustments have been brought in for 2022, which may affect how the interest on your tax is calculated.
You can explore these adjustments in more depth at the previous link, but here’s a quick overview of what’s changed:
- Married Couples Filing Jointly: Standard deduction rises by $800 to $25,900
- Single Taxpayers/Married Couples Filing Separately: Standard deduction rises by $400 to $12,950
Note: This information is correct at the time of writing. For the most up-to-date figures, consult the IRS website for more information.
How To Avoid Tax On Savings Account
If you want to protect your savings, the good news is that it is possible to protect your savings against tax – but probably not completely. Here are a few ways to soften the blow and make your money go further.
401k Accounts (Including Employer-Sponsored Accounts)
With this savings account, you can put part of your paycheck towards your retirement, and you won’t be taxed on ANYTHING you put into the account.
This also has some knock-on benefits, as it means you’ll actively lower your taxable income with each deposit you make.
Sometimes, your employer will also contribute money to your account, which can make your savings even larger.
The best bit? Any earnings you make will remain untaxed until you withdraw them. When you withdraw, both your earnings and contributions will be taxed at your current income tax rate.
Education Savings Account
Opening an education savings account can protect your investments from tax if you’re saving specifically for education. There are a few accounts you can create, including:
These are bonds sold by the government to support public improvement and education. Any interest you earn on municipal bonds is often free from federal tax.
If you’re living in the state where the bonds were issued, you may also be exempt from local and state tax.
If you invest in municipal bonds, you can support community projects while earning tax-free interest.
With a 529 account, you can save towards post-secondary and K-12 education.
You can either do a prepaid tuition plan (where you pay for future attendance) or do a savings plan. These are invested, and any earnings will continue to grow tax-free.
Other Tips For Avoiding Tax On Savings
If none of these options seem feasible, don’t worry! There are plenty more ways to reduce the tax bill on your savings account. If you want to explore other options, you can also try:
- Permanent Life Insurance Policies: Money will grow each year through dividends. In most cases, they are not subject to tax. If you withdraw money that you’ve deposited into the account, you also won’t have to pay tax.
- Coverdell Education Savings Accounts: These accounts can be used to pay for education expenses. For qualifying expenses, most distributions are tax-free. However, if any money remains in the account when the beneficiary turns 30, it will be taxed.
- Health Savings Accounts: Health Savings Accounts (or HSA) can offer tax relief to individuals while paying for healthcare expenses. Anyone with high-deductible health insurance can open one (a minimum annual deductible of $1,400). Because you contribute before you pay tax on your earnings, you can grow your interest tax-free.
- Flexible Savings Accounts: These work in a similar way to Health Savings Accounts, but in some cases, they can also be used toward childcare expenses. However, these accounts must be opened by an employer, and they don’t roll over – in other words, if you don’t spend your money, you’ll lose it.
The Bottom Line
Avoiding extortionate tax rates on your savings doesn’t have to be a headache.
Thankfully, there are many options out there and plenty of savings accounts that have been designed specifically to maximize your financial growth.
So, whether you’re saving for education, medical fees, or just everyday life, there’s bound to be a scheme to suit you. For the most up-to-date information, consult the IRS website or talk to a financial advisor today.