(NewsNation) — With interest rates at their highest level in years, high-yield savings accounts have become a popular, risk-free way for savers to earn money on their deposits but they could also lead to a larger tax bill.
After hovering around 1% for much of the past decade, the top savings account yield is now at 5.35% APY, according to Bankrate. That’s good news for those looking to grow their savings but it’s important to remember Uncle Sam takes a cut.
The Internal Revenue Service (IRS) treats the interest earned on a savings account as ordinary income, which means you’re taxed at the same rate as your income.
For instance, a single filer who earned $2,500 in interest in 2023 would owe about $600 in federal taxes if they’re in the 24% income tax bracket. That tax is calculated based on the interest you made, not the principal in your account.
Look for the 1099-INT tax form sent out by your financial institution to determine your interest income. Anyone who’s earned more than $10 in interest should have received one.
This year’s tax liability may come as a surprise to some who have learned about high-yield savings accounts on Financial TikTok where influencers often tout the benefits as “free” money.
Here’s what else to know about high-yield savings accounts.
Traditional savings account vs high-yield savings account
High-yield savings accounts are like traditional savings accounts except they tend to pay a much higher annual percentage yield (APY), which means your money grows faster as it sits there.
One of the reasons those accounts offer higher rates is because they’re often with online banks that tend to have lower overhead costs than traditional banks with brick-and-mortar locations.
That doesn’t mean your money is any less safe in a high-yield savings account so long as the financial institution is federally insured.
Some high-yield savings accounts have minimum deposit requirements and monthly service fees, while others compound less frequently, so it’s worth researching to find the best one for you.
Keep in mind that you’ll have to pay taxes on the interest you earn whether you use a traditional or high-yield savings account.
How big is the difference?
The national average yield for savings accounts is currently 0.57% APY, whereas, the top high-yield savings accounts earn above 5%, according to Bankrate.
At 5% APY, a deposit of $5,000 left untouched with no other contributions would leave you with $5,250 after a year. By comparison, a savings account at a 0.57% interest rate would leave you $28.50 richer a year later.
The APY on both types of savings accounts can change depending on the economy and interest rate environment, which means returns can fluctuate over a year.
“(A bank) may increase its rate as part of a promotion to attract more deposits, or it may adjust rates in response to broader economic factors, such as changes to monetary policy by the Federal Reserve,” Bankrate notes.
With rate cuts expected, the current APY on savings accounts could go down later this year.
Is there a downside to high-yield savings accounts?
High-yield savings accounts are a popular way to build an emergency fund because they offer easy access to cash and better returns than a regular savings account without additional risk.
But over the long run, you may get higher returns investing your money rather than stashing it in a savings account.
From a tax perspective, selling a long-term asset like a stock is typically taxed at a lower rate than ordinary income, even if you make money on it.
For example, a single filer who holds a stock for more than a year and sells it for a $2,500 gain would owe 15%, or $375, if their income was between $44,625 and $492,300 in 2023.
Another downside is that many online banks don’t offer ATM or branch access which means you might not be able to withdraw funds from your high-yield account in person.