Do You Have to Pay Taxes on Money Market Withdrawals?
Understand the tax implications of money market withdrawals, including reporting requirements and potential penalties for misreporting.
Money market accounts are a popular choice for investors seeking stability and liquidity, often offering higher interest rates than traditional savings accounts. Understanding the tax implications of withdrawing from these accounts is essential to avoid unexpected liabilities.
Navigating taxes on money market withdrawals requires distinguishing between different types of income and knowing how to report them accurately.
Income vs Return of Capital
When withdrawing from money market accounts, it’s crucial to differentiate between income and return of capital, as they have distinct tax implications. Income from these accounts typically comes in the form of interest, which is taxable. This interest income is reported on Form 1099-INT and must be included in your taxable income for the year. The tax rate applied depends on your overall income bracket, ranging from 10% to 37% under current tax laws.
A return of capital, however, is not taxable. It represents the return of your original investment. If withdrawals exceed your original investment, the excess may be treated as a capital gain and taxed at capital gains rates. This distinction is fundamental for accurate tax reporting.
How to Report on Your Tax Return
Accurately reporting money market withdrawals ensures compliance and helps avoid penalties. This involves understanding the necessary forms, potential withholding requirements, and deductible expenses.
Relevant Forms
Form 1099-INT is the primary document for reporting interest income from money market accounts. It details the total interest earned over the tax year, which must be included in your taxable income. If the account is held within a brokerage account, you might receive a consolidated 1099 form covering interest, dividends, and other income types. For accounts held abroad, Form 8938 may be required under the Foreign Account Tax Compliance Act (FATCA) to report foreign financial assets.
Possible Withholding
Money market accounts generally do not have withholding requirements. However, backup withholding at a 24% rate may apply if you fail to provide a correct taxpayer identification number (TIN) to your financial institution. This withholding is credited against your total tax liability and will be noted on Form 1099-INT. Additionally, if subject to the Alternative Minimum Tax (AMT), interest income from specific private activity bonds may be included in your AMT calculation.
Deductible Expenses
Interest income from money market accounts is generally taxable, but certain related expenses may be deductible. Fees for investment advice or account management may qualify as miscellaneous itemized deductions if they exceed 2% of your adjusted gross income (AGI). However, the Tax Cuts and Jobs Act of 2017 suspended these deductions through 2025. If the account is used for business purposes and you are self-employed, related expenses may be deductible as business expenses on Schedule C. Consult a tax professional to determine what deductions may apply to your situation.
Penalties for Misreporting
Misreporting income from money market withdrawals can result in significant penalties. The IRS enforces compliance with tax laws, and discrepancies can trigger audits, fines, and other consequences.
One common penalty is the accuracy-related penalty, which can be as high as 20% of the underpayment of tax due to negligence or disregard of rules. In cases involving fraud, penalties can escalate to 75% of the underpayment. Additionally, failing to report foreign income or assets, including foreign money market accounts, can lead to severe penalties under FATCA and FBAR requirements. For example, failing to file an FBAR can result in penalties of up to $13,481 for non-willful violations, and the greater of $100,000 or 50% of the account balance for willful violations.
Document Retention
Keeping organized records is critical when managing money market accounts and preparing for tax reporting. Proper document retention helps resolve disputes and ensures compliance. Retain account statements, transaction records, and communications with financial institutions to verify income and transactions.
The IRS generally recommends keeping records for at least three years, aligning with the statute of limitations for audits. However, if income is underreported by more than 25%, the statute extends to six years. Records related to asset purchases and sales should be kept until the statute of limitations expires for the year in which the asset is sold.