How to Avoid Tax on Savings Account

Interest earned on traditional savings accounts is considered taxable income by the Internal Revenue Service (IRS). Understanding legal methods to minimize or defer this tax can help individuals maximize their financial growth.

Understanding Savings Account Taxation

Interest income from regular savings accounts is subject to taxation as ordinary income. This means it is taxed at the individual’s marginal income tax rate, which varies based on their overall income level. Financial institutions issue Form 1099-INT, Interest Income, to account holders when interest earned exceeds $10. This form details the total interest paid during the calendar year, which must be reported on a tax return.

Even if the interest earned is less than the $10 threshold, the income is still legally reportable to the IRS. This interest is added to other income sources, potentially increasing an individual’s overall tax liability.

Leveraging Tax-Advantaged Accounts

Utilizing specific tax-advantaged accounts offers a direct way to manage the tax implications of interest income. These accounts provide structures where interest can grow tax-deferred or entirely tax-free, depending on the account type and how funds are used.

Individual Retirement Accounts (IRAs)

Individual Retirement Accounts (IRAs) are a primary tool for long-term savings with tax benefits. A traditional IRA allows for tax-deferred growth, meaning any interest or earnings within the account are not taxed until funds are withdrawn, typically in retirement. Contributions to a traditional IRA may also be tax-deductible, reducing current taxable income.

In contrast, a Roth IRA offers tax-free growth and tax-free qualified withdrawals in retirement, provided certain conditions are met, such as the account being open for at least five years and the account holder being at least 59½ years old. The annual contribution limit for both traditional and Roth IRAs is $7,000 for 2024, with an additional catch-up contribution of $1,000 allowed for individuals aged 50 and over.

Health Savings Accounts (HSAs)

Health Savings Accounts (HSAs) provide a triple tax advantage for individuals enrolled in a high-deductible health plan (HDHP). Contributions to an HSA are tax-deductible, reducing taxable income in the year they are made. The funds within the HSA, including any interest earned, grow tax-free. Qualified withdrawals used for eligible medical expenses are also tax-free. For 2024, the contribution limit for self-only HDHP coverage is $4,150, and for family HDHP coverage, it is $8,300, with an additional catch-up contribution of $1,000 for individuals aged 55 and over.

529 Plans

A 529 plan is designed for education savings. Contributions to a 529 plan grow tax-free, and qualified withdrawals for eligible educational expenses are also tax-free. This includes tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. The tax-free growth within a 529 plan allows the savings to compound more effectively.

Income Shifting and Other Strategies

Beyond specific tax-advantaged accounts, certain income shifting strategies can also help reduce the overall tax burden on savings interest. These methods involve directing income to individuals in lower tax brackets or managing one’s own taxable income more broadly.

Gifting Funds

One strategy involves gifting funds to a family member, such as a child or grandchild, who is in a lower income tax bracket. When these gifted funds are placed into an account in the recipient’s name, any interest earned on that money is then taxed at their marginal rate, which is likely lower than the original owner’s rate. For 2024, an individual can gift up to $18,000 per recipient without incurring gift tax or affecting their lifetime gift tax exclusion. However, it is important to consider the “Kiddie Tax” rules, which apply to unearned income of children below a certain age. For 2024, if a child’s unearned income, including interest, exceeds $1,300, a portion of it may be taxed at the parents’ marginal tax rate, limiting the effectiveness of this strategy for very high amounts of interest.

Managing Overall Taxable Income

Managing one’s overall taxable income is another indirect but effective way to minimize the tax on savings interest. By strategically utilizing available deductions and credits, individuals can lower their adjusted gross income (AGI), which in turn can reduce their marginal tax bracket. A lower marginal tax bracket means that any taxable interest income will be subject to a reduced tax rate. This approach focuses on reducing the tax rate applied to interest, rather than eliminating the interest itself from taxation.

Reporting Interest Income

Accurate reporting of interest income to the IRS is important for all taxpayers. Financial institutions provide Form 1099-INT to report taxable interest income to both the taxpayer and the IRS. This form is used for preparing one’s annual income tax return.

Taxable interest income, as reported on Form 1099-INT, is reported on Schedule B, Interest and Ordinary Dividends, if the total taxable interest exceeds $1,500. If the amount is $1,500 or less, it can be reported directly on Line 2b of Form 1040, U.S. Individual Income Tax Return. Even if a taxpayer does not receive a Form 1099-INT because the interest earned was less than the reporting threshold, the income must still be reported.

Certain types of interest, while not subject to federal income tax, may still need to be reported. For example, interest earned from tax-exempt municipal bonds is not subject to federal income tax, but it is still reported on Line 2a of Form 1040. This distinction between reporting and taxation is important for compliance.