Taxes on Interest and How to Keep More

The rate a bank advertises is not the rate you keep. Interest is taxed as ordinary income, usually at your highest bracket, and most states tax it again. After tax and inflation, a good savings rate often does little more than hold its ground, which is exactly what cash is for, but it means the choice of account type can matter as much as the choice of bank. This chapter shows how interest is taxed, how to work out the rate you actually keep, and the legal ways to keep more of it: Treasury and municipal income, timing, and where you hold cash.

Interest is ordinary income

Interest from savings accounts, money market accounts, CDs and Treasury bills is taxed federally as ordinary income, at the same rates as wages. Dividends from money market funds are treated the same way; they do not get the lower rate that some stock dividends receive. Banks report interest on Form 1099-INT and funds report their dividends on Form 1099-DIV, but the income is taxable whether or not a form arrives.

Interest is generally taxable in the year it is credited to your account, even if you leave it there. A CD longer than a year is taxed on the interest that builds up each year, even if the bank pays it all at maturity. Treasury bills are the exception that works in your favour: their interest is taxed when the bill matures.

Because interest is added on top of your other income, it is taxed at your marginal rate, the rate on your last dollar, not your average rate. For a single filer earning a salary, here is the federal tax with and without a year's interest on a cash reserve:

The reserve earns $2,000. On a salary of $90,000, federal tax rises from $10,970 to $11,410 once the interest is added, because every extra dollar falls in the 22.0% bracket, even though the filer's tax as a share of gross income is only 12.4%. The tax bracket calculator shows your own marginal rate.

The rate you actually keep

Your after-tax rate is the APY times what is left after your marginal federal and state rates: after-tax rate = APY × (1 − federal rate − state rate). Then subtract inflation, using the Fisher equation from chapter 1, to get what the money gains in buying power.

Take a 4% APY, the 22% federal bracket and a 5% state rate. The after-tax rate is 4% × 73%, about 2.92%. With prices rising 3% a year, that is a real return just below zero.

After five years, the reserve buys about what $19,922 buys today. That is a good result for cash. The reserve kept its strength while staying safe and available, and chapter 1 showed what happens at a low rate instead. It also shows why cash is the wrong home for long-term money, and why squeezing out the tax can be worth real effort for larger balances.

Treasury and municipal income: skipping a layer of tax

There are two main ways to take a layer of tax off cash.

Treasury income skips state tax. Interest on Treasury bills and other Treasury securities is exempt from state and local income tax, and Treasury money market funds pass most of that through. Chapter 5 worked through how much that is worth in a high-tax state.

Municipal income skips federal tax. Interest on debt issued by states, cities and their agencies is generally exempt from federal income tax, and usually from your own state's tax when the issuer is in your state. Municipal money market funds hold this debt. Their yields are lower than taxable funds' yields, so the fair comparison is the tax-equivalent yield: tax-equivalent yield = tax-free yield ÷ (1 − your tax rate).

The result depends heavily on your bracket. A municipal fund yielding 2.8% is worth about 4.1% in taxable terms to someone in the 32% federal bracket, which would beat a 4% taxable fund. To someone in the 12% bracket it is worth about 3.2%, which would not. Municipal funds are mainly a tool for high earners, especially in high-tax states that also exempt their own bonds.

Two cautions. Tax-exempt interest still counts in some calculations: it is added back when working out how much Social Security is taxable and whether Medicare premiums rise, and interest from certain "private activity" bonds can be subject to the alternative minimum tax. And a municipal money market fund is a fund, with the same lack of insurance described in chapter 3.

The Net Investment Income Tax

Higher-income households owe an extra 3.8% federal tax on investment income, including interest and money market fund dividends. It applies to the smaller of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 (single or head of household) or $250,000 (married filing jointly). Those thresholds are set in law and are not raised for inflation, so more households cross them each year. Interest on municipal bonds is not counted as net investment income, which adds to their appeal for people above the line.

Timing and location

Some of the most useful moves are about when interest is taxed and where it is earned.

• Move interest into next year. A Treasury bill bought in the second half of the year that matures in January is taxed in the following year. That helps most when you expect lower income next year.
• Deduct early withdrawal penalties. A penalty for breaking a CD early is deductible as an adjustment to income, whether or not you itemize.
• Defer with I bonds. I bond interest is not taxed until you cash the bond, for up to 30 years.
• Hold long-term cash and bonds in tax-advantaged accounts. For an emergency fund this does not apply, because the money must be reachable without penalties. But if your long-term plan includes bonds or cash, holding them inside a 401(k) or IRA shelters their interest, while stocks, which are taxed more lightly, sit in taxable accounts. The asset location calculator estimates what that placement saves.

Losses on short-term bond funds

Savings accounts, CDs and stable-price money market funds do not lose value, so they never produce a capital loss. Short-term bond funds, which some people use as a step up from cash, can. If you sell one for less than you paid, the loss offsets capital gains, and up to $3,000 a year of any remaining loss can offset ordinary income, with the rest carried forward to later years.

The wash sale rule disallows the loss if you buy the same or a substantially identical investment within 30 days before or after the sale. Switching to a different fund with a similar purpose generally keeps the loss, but whether two funds are "substantially identical" is not defined precisely, so be cautious with near-copies.