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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 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:
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:
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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Here are the IRS instructions for the IRS Form 2210, there are a couple exceptions for avoiding being penalized.
https://acrobat.adobe.com/id/urn:aaid:sc:VA6C2:3430a4f7-3df9-437b-aafe-49930bfba726
I know many HD readers do not love I-series bonds like I do, but they offer the saver CONTROL. The interest will not become taxed until you cash in a bond. So one will not be paying tax year after year as with savings or money market accounts or certificates of deposit. You control when the interest is taxed. Pick a low income year and redeem a bunch. And in IL and other high tax states, it’s a beautiful thing to see the subtraction of the interest in the state return since it is tax exempt. Savings, money markets, and cds do not bestow this state and local tax blessing.
PS For those getting a refund, you should consider applying it to your 2024 taxes, ie it becomes part of your estimated taxes.
Also, up to $5k of a tax refund can be sent to you via a paper I-series bond.
Rick, question for you regarding the safe harbor… as Andrew mentions, if we know this year will have lower income than last, the safe harbor practice means giving Uncle Sam an interest free loan. On the other hand, if we know income is going to be higher this year than last, as long as we make sure we pay 100% of the total tax from last year, we’ll owe our higher total tax in April but without penalty for underpaying.
I assume estimated payments or withholding must still occur, or can the 100% of last year’s total tax be paid at once in December? Thanks
Michael, as Randy states, it’s my understanding that taxes withheld are treated as split into the 4 quarters. This is defined in IRC Section 6654(g)(1) .
Thanks, I must not have asked my question clearly. I’m asking about a one time direct payment from me to the IRS in December, not a one time withholding. Normally this would not satisfy the requirement for estimated tax payments, unlike a one time withholding, and I’d owe a penalty. But, if it equaled 100% of the previous year’s tax bill, would I owe one then? Thanks
If it’s withheld, December’s payment is treated as split into quarters as Charles noted below.
As early retirees, our income continues to fluctuate due to rearranging holdings, conversions, etc., I’ve found it useful to use the previous years TT program to help guide estimated payments in the current year. Simply make a copy of your filed return within the software, give it a new name like, “2024 Q1 Estimate”, update your entries and see what pops up. I also have my own spreadsheet to estimate taxes.
A couple of caveats on Federal taxes to consider when using the previous years software that can also affect your state taxes:
Tax brackets, deduction, limits and the like will not be up to date of course but as they usually adjust favorably higher, I’m good with that added margin of safety.
The tax code has been relatively consistent year over year but things may change significantly starting in 2025.
Tax brackets and deductions are up to date when you use the TurboTax what-if worksheet. Switch to Forms view, Open Form and search for “what-if”. No need to make a copy of your return as the worksheet has the copy function built in.
GW, thanks for reading and commenting. I also like to se TT to do what if analyses, and I also have an Estimated Taxes spreadsheet that i use to track income though the year. I’ve had it set up for a number of years, so updating it for changes in the tax code is relatively easy. I even have a simple state tax model built in. What I don’t have is an option to use an itemized deduction – I may have to add that if we go back to previous rules after 2025 as you mentioned.
I use TT to file, but also created a spreadsheet to calculate federal and state taxes. I pay the safe harbor amount for estimated taxes for the first three installments, and then in December use the relevant draft IRS tax forms and tax tables to update the spreadsheet rows for the current tax year (state forms aren’t available until January, so I have to use the prior tax year line items updated with current tax year data).
This allows me to fine tune the amount I have to pay in estimated taxes for the January installment. I always overestimate a bit as a buffer. Also lets me play around with different typical end of year tax planning strategies, like Roth conversions and hypothetical realization of capital gains/losses, etc., with the effects displayed in side-by-side columns.
For the next year, I just make a copy of the previous year’s worksheets and modify them for that year’s data and changes.
Rick, thanks for an important article. I always just use the “safe harbor” method you reference when figuring our estimated payments and then don’t have to worry about it.
I guess the downside would be if I knew the upcoming year was going to have significantly less taxable income, in which case the safe harbor method would mean giving Uncle Sam an oversized interest free loan for the year.
Andrew, thanks for reading and commenting. Tracking your income throughout the year is a pain, but it was necessary when I started consulting. I’ve kept it up since then, so it’s not too bad now.
Easier to use your RMD withholding at the end of the calendar year. IRS credits as if quarterly payments made
Yes, that’s what I do.
Good point Charles. I’ve been thinking about an article on estimated payments and strategies to avoid penalties.
Great article Rick. Just in reading the lead sentence, my first reaction was to think of the advantages of keeping the lion’s share of one’s cash and bonds in tax protected accounts, and avoiding the issue altogether. When cash is needed, sell a bit of stock in the taxable account, and offset by shifting from cash to stock in a protected account. Generally the tax on any capital gain is going to still be less than that on interest.
Thanks Michael. Many financial planners agree that you should keep interest producing assets in tax-deferred accounts, and equities in taxable accounts for the reason you say.
We keep all but a few thousand dollars in our Vanguard Federal money market account as it pays significantly more than our credit union account. Never thought about the tax consequences. That’s just a bonus!
And it is paying over 5% still
I’ve found that few people understand how the extra income from interest income effects the taxation of their Social Security income. I know its been discussed here before, but the income threshold for taxing SS was established in the 80’s and (as you stated) has never been adjusted for inflation. It didn’t effect too many people 40 years ago, but it sure does now.
Yes, and when it affects a taxpayer, it effectively multiplies the marginal tax rate by 1.5 or 1.85; for example, the 12% bracket can become 22.2% for a range of income.
Dan, thanks for reading and commenting. Many folks are still very surprised that their SS benefits are taxed at all. We try to explain the interaction of increased income and more SS being taxable, but it isn’t intuitive. The worksheet the IRS uses is also confusing.
Thanks for the tax awareness article! We are having our taxes done today. I don’t think it’s going to be a good turnout because of the higher interest earned. Plus, we were advised in advance the fee (unknown) has gone up to have our taxes done. I miss being able to use the 1040EZ form.
Olin, thanks for reading and commenting. If your tax return is fairly straight forward, you cold consider going to a VITA or AARP TaxAide Site for free preparation. The preparers are well trained, experienced, and all returns are completely checked. We have many clients who came from paid preparers and they saved $200 to $400 preparation fees.
https://www.aarp.org/money/taxes/aarp_taxaide/
Usually the AARP tax preparation is not for high earners or complicated returns. Best to check first. Why pay a preparer? Do it yourself online. I’ve used Turbo Tax forever, and had very high income years and it was easy to file. One year I hired a CPA. He charged more but came up with nothing different than TT.
Rick, thanks for the AARP suggestion…I’ll look into that. A friend just had their taxes done and the fee doubled to around $650.
Last year I tried three different tax software programs and got 3 different answers, 4 if I count what my tax person came up with.
Rick, do you see most people actually needing a preparer as opposed to using TurboTax or similar tool? I have used TurboTax for years and find it easy with very good live assistance when needed. Do most people you see have that complex returns?
Dick, I’ve used TT myself for as long as I can remember and have had good success. When you say “most people” that is a pretty broad question. I would imagine many of the regular readers of HD are well prepared to do their own taxes. One way to answer the question is this data point. Every site I have supported over 6 years has been totally booked with long waiting lists. For whatever reason, it’s a service in demand.
The type of clients I have seen in 6 years of tax prep do vary, but the majority are seniors with generally straight forward returns. But many of them are not computer savvy, or apparently interested in learning. Taxes confuse and scare a lot of people it seems. IN NJ, the free tax sites not only do the federal returns, but state returns, and help out with property tax refund, including helping them fill out those forms which require tax data. Here’s one way to think of it – If you weren’t available, for whatever reason, could your wife do your taxes?
One of the best parts of the service is that each return is generated by a certified preparer, then completely checked by another verified preparer. Clients are effectively getting their returns done twice for free. And they are filed electronically for free. It is a great service that the IRS sponsors, and volunteers provide.
And it’s not just seniors. I’ve also helped single moms, disabled veterans, small business owners, and a wide variety of citizens. I think many of HD readers are financially savvy and successful and may not need this service. It’s humbling to be exposed to a wide swath of society see what their financial reality looks like. I’m glad I can help.
Mr Quinn. I know you directed your question to Rick but thought I’d add that I’ve also used TT for years and generally been happy with it. Yesterday I did our taxes but their software made a very basic mistake in one section. I talked with 2 of their “experts” for over an hour and they couldn’t solve it. After the calls I found a workaround myself. My only consolation was that in the end, while my returns were more complex than ever, both the Fed and State were free.
Once again I find myself on the outside looking in because of my inefficient ways.
Only once have we owed taxes at year end. Rather we receive a decent refund.
I have withholding from my pension and from Social Security as a percentage of the payment. But the real strategy is extra withholding I have on my gross RMD (before QCD) in December. That is typically 3-5% higher than my usual tax bracket.
Sure, I’m giving Uncle Sam a free loan, but since it’s actually only for a month or three before I get my refund, the cost is quite negligible and I avoid tax filing stress and surprises and the requirement to file estimated taxes.
Fidelity will let you withhold up to 99% of your IRA withdrawal. This has been very useful for me – I typically withhold 60% Federal and 39% state, which covers the tax on all my income, with 22% withholding on SS. But I do have to take a little higher than the RMD to make sure I’ve covered my taxes.
We sold some holding in December and made an estimated tax payment in January as a result. As it happened I overestimated the total tax for the year and we got a refund in excess of the estimated payment soon after. Oh well. I’d do the same thing again to make sure we avoid a penalty.
Michael, the first year I did consulting I did something similar. I made a large estimated payment in January. I had opened a solo 401K in December. I realized I could make a large contribution before April 15, and go most of estimated payment back.
Dick, thanks for reading and commenting. Don’t feel bad, I see many clients who follow your lead, withholding enough to get a large return in April. We even see folks who have state withholding on retirement income in NJ, even though they are well below the state’s threshold for pension exclusion. Each year they send money to Trenton, only to get it all back in May or June. This article highlighted (or tried) when taxpayers get a windfall and aren’t prepared for the tax implication.
As of the first quarter of 2024 the interest rate on underpayments is 8% for individuals —more than doubled from 3%—so more important than ever to get it right.
Good article, Rick.
What’s irritating about the IRS and this whole issue is that it’s confusing to figure out what constitutes underpayment. We just did 2023 taxes and even though we have a $80 refund from Federal, we have an underpayment penalty because we only made a $5000 payment in Q4 to cover a $60K Roth conversion. Additionally, +/- 40% of our interest and dividend income came in Q4, so we did not owe taxes until we decided to capitalize on the market correction in Oct to buy stock and do the Roth conversion. We still had to pay a penalty, given we had no taxable income Q1-Q3 that wasn’t covered by our deductions. Based on the complicated Form 2210 and its schedules, we ended up owing $22 in penalty.
To add insult to injury, when the IRS lost our 2021 return (resulting in hours of time chasing them, as well as refiling the same return a year later as they recommended), our refund of $3700, — finally return processed but refund still not paid yet, has not been adjusted for any interest.
Clarke, I can understand your frustration—form 2210 is mind boggling. The problem with making one estimated tax payment in last quarter is that the IRS computer records read it as being owed evenly throughout the year, according to Laura Sanders of the WSJ.
However, you can still request an abatement of penalty, even if you have already sent in your return by filing form 843.
i hope you have received your refund.
Resolutions are slow. Trouble is the IRS is now a revenue collector, a stimulus disburser, a welfare provider and tax enforcer. And now they want to be your tax preparer.
Good luck.
Thanks Marjorie. Our CPA prepared the form so I’m guessing she knew how to file the form. Still have not received the refund even though they sent a notice in December 1 saying they adjusted my refund upward due to an error on the advanced premium tax credit. They give you only the option to “not contest” the new refund amount, in which case they say wait 6-8 weeks. It’s now been 4 months. 2 years later on, no interest to them holding on to my refund, but a whopping 8% interest if you “underpay.”
The $80 penalty isn’t enough for me to care about, but it’s the principle that irks. Now if I want to avoid the underpayment for 2024, I’m going to have to handover money quarterly even though I’m not sure I will do the Roth conversion in 2024 or how much, and may have no tax liability. Now how is that fair?
I shared a link of the instructions to Form 2210 as a new separate comment above.
In the instructions there is an alternative method to compute the penalty amount due, named “the annualized income installment method.” Please consider using this worksheet whenever your income is backloaded to the second half of the year.
Good point Marjorie, thanks.
I had a record haul of interest payments last year, coming from high interest savings, a CD, and a bunch of paper I bonds I redeemed. Income came from 2 different employers and I itemized my deductions. Can’t imagine managing all that without a spreadsheet. I ended up owing $129.
Ken, thanks for reading and commenting. I imagine you and I approach our returns similarly – considering owing a small amount a win. I like to owe a few hundred, but less than the $1,000 mark. Well done.
Yes, indeed. I know a couple of folks who were surprised to learn they had overlooked tax underpayment and owed a penalty for 2023.
Edmund, thanks for reading and commenting.