How is a savings account taxed?

The amount you make on a savings account is probably quite low, even if you're keeping a sizeable balance in it. Still, whatever interest you earn on the account is considered to be taxable income by the Internal Revenue Service, and must be reported on your tax return.

Savings accounts are not generally thought of as investment vehicles. However, the IRS considers any interest-bearing financial instrument to be an investment for tax purposes.

You are taxed on any interest earned in the account over a minimum of $10, although financial advisor Rebecca Dawson of Silber Bennett Financial in Los Angeles, Ca. warns that "the IRS requires you to report all taxable interest in your income. If you accepted a cash incentive from the bank to open a new savings account, that bonus is also taxable and needs to be reported as well," she adds.

Interest from a savings account is taxed at the marginal rate. In other words, if your regular income tax bracket places you in a 35% bracket, then the interest on your savings account is taxed at that rate.

For tax purposes, what happens to interest after you earn it is inconsequential; it will be taxed the same way regardless of whether you keep the money, transfer it to a new account, or spend it.

Though the earned interest on savings accounts is taxed, you will not have to pay taxes on the account's balance. If your savings account has $10,000 and earns 0.2% interest, you are taxed just on the $20 in interest the bank credits to you, not on the hefty principal that drove those earnings.

Certain types of accounts, such as individual retirement accounts, allow interest on savings to accrue tax-deferred, and those earnings need not be reported. As Dawson says, "these rules only apply to traditional or online savings accounts. They are not to be confused with savings held in an IRA. The interest on those [accounts] is tax-deferred: You pay taxes on it only when the funds are withdrawn." (in fact, if that IRA is a Roth, you don't even pay taxes on the earnings when you do withdraw it, as long as you have reached age 59½.)

According to financial advisor Dawson, in late January or so every year, "the financial institution that holds your savings account mails a form 1099-INT, showing interest earned in the previous year." That form must be sent to the IRS when you file your tax return.

More information on the taxation of interest received can be found in Topic 403 on IRS.gov. Backup withholding information is discussed in Topic 307.

As negligible as the interest earned on a savings account may seem, Dawson says it's unwise to neglect reporting it. "If your taxes are not paid on the interest earned in your savings account, the IRS will enforce penalties and fees."