Don’t be caught off guard.
- A savings account is a good place to store your emergency fund and money you’re not ready to invest.
- The interest income you receive could trigger a tax liability, so it’s important to be prepared.
If you have money that you don’t plan to use for a long time, a savings account might not be the best place for it. Indeed, you will only earn a limited amount of interest by keeping your money in savings, whereas if you invest it in a brokerage account, it could reach a much larger sum.
But the money you’ve designated as your emergency fund definitely needs to be lying around in your savings account. The same goes for any funds you may need over the next few years, such as money you’re hoarding to buy a house.
In the meantime, if you’re tired of earning minimal interest on your savings account, here’s some good news. The Federal Reserve is moving forward with a series of planned interest rate hikes. In this case, savings accounts should start paying more generously. But while that’s clearly a good thing, it could lead to a tax consequence that you may not be prepared for.
Your money is not entirely yours
Just as you are required to pay taxes on income you earn from your primary or secondary job, the IRS also receives a portion of the interest income you earn from your bank. And now that savings account rates are about to rise, you could end up owing the IRS more by collecting more interest.
Is this a reason to withdraw your money from a savings account? Absolutely not. Unless you really have a plot 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. This means that it is taxed at the highest rate you are subject to.
Remember that US taxes operate on a marginal basis, so you pay a lower tax rate on your lower income and a higher rate on your higher income. And so if the interest rate on your savings account goes up and you have a decent balance, you should be prepared to pay more money to the IRS. That could mean writing a bigger check or getting a smaller refund during tax season.
Are rising interest rates a good thing?
Rising savings account rates are a good thing because it means you’ll earn more on the money you’ve deposited in the bank. But rising credit card interest rates, for example, is a bad thing. If you have 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. So in the coming months, we might see savings accounts start paying more interest, but we might also see consumer spending decline as borrowing becomes more expensive. This could, in turn, lead to a recession, so this is something we will have to watch.
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