The dark side of high-yield savings accounts

By Richard Connor

Savings account interest counts as taxable income

Savings yields soared in 2023-and all that interest income is now showing up on people's tax returns.

Forbes published historical average money-market rates based on FDIC data. The average rate in 2020 and 2021 was 0.1%. That jumped to 0.15% in 2022 and 0.59% in 2023. But remember, those are averages, and it isn't difficult to find higher yields. For instance, interest rates on high-yield savings accounts are up sharply since spring 2022.

I looked at the yield on my Capital One (COF) online savings account for the past few years. The rate was 0.4% on Jan. 1, 2022, 3.3% on Jan. 1, 2023, and 4.35% on Jan. 1, 2024. Let's assume you had $10,000 in a Capital One savings account on Jan. 1, 2022. By the end of the year, it would have grown to $10,138, an increase of $138. If you didn't touch it, during 2023 it would have continued to grow to $10,544, up another $406. The interest earned in 2023 was almost three times as much as in 2022.

Savings account interest-assuming the money isn't held within a retirement account-counts as taxable income on your federal return, and also in most states. In the initial weeks of tax season, I've prepared returns for several clients who have seen significant increases in their interest income. One client went from about $6,000 to $24,000. Another went from $2,000 to $17,000.

Both were quite surprised by the increase-and by the tax implications. These two clients were in the 22% marginal tax bracket. Each additional $1,000 of interest meant an additional $220 of federal tax owed.

In both cases, the clients were also collecting Social Security benefits. They received an 8.7% increase in 2023. But there have been no changes in the limits on how much income you can collect before benefits become taxable. The combination of increased Social Security benefits and increased interest income meant more of their Social Security was taxable. This also led to significantly increased tax bills. One client owed about $6,000.

But that wasn't the only shock. Our income tax system is a pay-as-you-earn system. The IRS expects us to remit income taxes throughout the year as we receive our income. For most workers, employers withhold taxes. Meanwhile, self-employed taxpayers are required to pay quarterly estimated taxes. Retirees may also have to make quarterly estimated tax payments if they don't withhold enough during the year.

If you don't pay enough taxes during the year, either through withholding or estimated payments, you could be liable for a penalty. And even if you made estimated payments but were late doing so, you could find yourself in the strange situation of paying a penalty even though you're due a refund when you file your tax return.

How do you figure out whether and when to file estimated taxes? The IRS recommends you file estimated taxes if you expect to owe more than $1,000 when you file your return. The IRS has a useful tax withholding estimator.

Consider a simple scenario based on one of my clients. Mary is age 66 and retired. This will be her situation in 2024:

Mary's pension will be $48,000, with 10% withheld for federal taxes.Mary's Social Security will be $24,000, with no taxes withheld.Her expected interest earnings are $6,000.

In this scenario, Mary would owe $2,986 in federal taxes when she files her return, on top of the taxes already withheld. What if her interest income ballooned to $24,000? The federal taxes she owed would also balloon, to $6,946. Both amounts could lead to a penalty. How could Mary avoid a penalty? The IRS provides the following guidance:

Withhold enough-or make big enough estimated payments-through the year so you owe less than $1,000 on your return.Through estimated payments and withholding, pay at least 90% of the tax shown on the return for the current tax year or 100% of the tax shown on the return for the prior year, whichever amount is less. For high-income earners, that 100% becomes 110%.

This column first appeared on Humble Dollar. It was republished with permission.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

-Richard Connor

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03-16-24 1711ET

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