Just about any kind of income you can think of is taxable by the Internal Revenue Service. Wages, salaries, tips, gambling winnings, baby-sitting for your neighbor's children and even income from illegal activities are examples of taxable income. It should come as no surprise that the IRS considers the interest on your savings to be taxable, too, although there are a few exceptions.
The IRS considers interest that is paid to you or credited to your account to be taxable income. This includes interest on passbook savings accounts, interest-bearing checking accounts, money market accounts and certificates of deposit. The interest on your savings is taxable even it if is called by a different name. For example, if you keep your savings in a credit union or a money market mutual fund, your financial institution may refer to your distributions as dividends. For tax purposes, the IRS considers these distributions to be taxable interest income.
You typically have to pay income taxes on your savings interest in the year it is made available to you or credited to your savings account or other type of account. This is true regardless of whether you withdraw those funds or leave the money in the account. You are responsible for paying taxes each year on interest earned by a long-term certificate of deposit, even though you can't access those funds without incurring an early withdrawal penalty.
Certain investments allow you to defer paying taxes on your savings interest until a future date, and others allow you to avoid paying taxes at all. You can defer paying taxes on the interest earned by your Series EE and Series I U.S. savings bonds until they mature, and if you cash in these bonds to pay for qualifying educational expenses, the interest is free from federal income taxes. The taxes on your retirement savings held in a traditional individual retirement account are deferred until you withdraw the funds. Qualified withdrawals from a Roth IRA are completely free from federal income taxes. The interest earned by money market mutual funds that invest exclusively in tax-free municipal bonds is free from federal income taxes, although any capital gains produced by the fund will be subject to taxation.
Any organization that pays interest on your savings should provide you with a Form 1099-INT detailing the amount of interest it paid. You are required to report all of your interest, regardless of whether you received this form. As of 2012, report the amount of interest you received on Lines 8a and 8b of IRS Form 1040. You might also have to complete and attach Schedule B, "Interest and Ordinary Dividends."
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.