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Managing Your Money

Reducing Taxes on Interest: Try Replacing Your Savings Account with Smart Saver

Learn how you can help minimize taxes on earnings by focusing on state and local tax advantages with savings account alternatives.

Articles by Eric Bronnenkant

By Eric Bronnenkant
Head of Tax, Betterment  |  Published: September 28, 2018

Using New York as an example, you’d likely need a 2.38%* rate from a traditional savings account to keep up with Smart Saver.

Download a copy of our savings account interest calculator to compare Smart Saver to your savings account.

You probably only think about taxes on interest once per year: That moment when you enter your earnings number from a 1099-INT—that form you get from a bank—and put it into your tax software. (Or, if you use an accountant, they do it for you.)

But that moment is an important one. That number gets added to your wages and salary to help determine how much you’ll pay in federal taxes. Then, when you file your state and local taxes, that interest gets taxed yet again.

So, what if I told you there was a way to help reduce how much of that interest gets taken away by taxes? If you’re socking away tens of thousands in a high-yield savings account, then your earnings can easily be in the hundreds. Would you rather have $20 taken away in tax? Or does $15 sound better? It may sound small, but if you’re attuned to earning as much income on your savings as possible—without investing in aggressive investments—you probably want to save as much as you can in taxes. In this article, we’ll describe how to save on taxes with an alternative to your savings account.

Plus, you can download a copy of our calculator to compare Smart Saver to your savings account.

Meet Smart Saver, a savings alternative with tax advantages.

Smart Saver is Betterment’s savings alternative with built-in advantages when it comes to state and local taxes. More than that, it has built-in cash analysis to help you identify an appropriate level of cash to hold in your checking account and Two-Way Sweep, a feature that helps you save more of your money each month.

To put it briefly, here’s how Smart Saver can help you save on taxes:

  • Your money is put in a low-risk portfolio with a set mix: 80% U.S. government bonds and 20% investment grade corporate bonds.
  • On your federal tax return, your earnings from Smart Saver are taxed the same way a bank’s savings account interest is taxed.
  • On your state tax return, approximately your earnings from U.S. government bonds are not taxable. Meanwhile, any earnings from a savings account can be taxed by states and municipalities.
  • If your state doesn’t have an income tax, then there’s no tax benefit of using Smart Saver, but our helpful savings tools may still be advantageous for you.

To understand the difference between taxes on savings accounts vs. Smart Saver, you can look into each below or get a copy of our calculator (must be logged into a Google Account to use) that might help you picture the comparison.

But here’s a simple example: If you live in New York, you’d likely need a 2.38 rate from a traditional savings account to keep up with Smart Saver.

* Read more about how we determined that rate—and check out the calculator to see for yourself.

Taxes on Your Savings Account: A Quick Review

You may forget year-to-year that the interest you earn on your savings account is taxed. For all U.S. taxpayers, the interest your bank or credit union pays back to you is added to your other earnings (salary, wages, capital gains, etc.) to total your gross income on a tax return. After accounting for adjustments and deductions, this amount becomes your taxable income, which is the main input into how much you are taxed.

Most states and localities with an income tax use your Federal tax return as a starting point, and then make state-specific adjustments, one of which directly relates to your cash savings. States consider your bank account interest in your taxable income, but they do not consider U.S. Treasury bonds—which make up a large majority of the Smart Saver portfolio—to be taxable, due to federal law.

Why is this important? Both U.S. Treasury bonds and bank products (like savings accounts) are often viewed as stable places to earn interest on extra cash. The difference in how states and localities tax each form of income, however, changes how much of those earnings you get to keep each year.

Using U.S. Treasury Bonds for Tax-Advantaged Cash Savings

Because states and localities can’t tax U.S. Treasury bonds, it makes these bonds partially tax-exempt, compared to other savings vehicles, like a savings account. Accordingly, Smart Saver is tax-advantaged since its portfolio consists of 80% of U.S. Treasury bonds (the remaining 20% is invested in low-volatility corporate bonds).

Put another way, U.S. Treasury bonds, when purchased and managed effectively, can make for a tax-advantaged alternative to a conventional savings account, in which your money is entrusted to a bank, without tax advantages.

To make this comparison feasible, however, there are a few details to remember.

  1. Interest rates vary broadly on savings accounts. So, before even considering the tax-advantages of U.S. Treasury bonds, it’s worth considering the rate alone. Since the average bank’s savings account APY falls well below 1% currently, an improved rate alone may be a reason to consider an alternative. Conversely, you may be able to find a top savings account that compensates you enough to offset your potential state and local tax savings.
  2. Remember that the tax advantage of U.S. Treasury bonds is only useful if you currently face state and local income taxes. If your state doesn’t have an income tax, then this tax advantage is moot for you. Use our Smart Saver vs. Savings Account calculator if you’re not sure.
  3. Savings accounts are designed to give you liquid access to your money. U.S. Treasury bonds are liquid but withdrawals from Betterment take approximately 4-5 business days.

Using Smart Saver as a Savings Account Alternative

We designed Smart Saver to give you access to the tax advantages of U.S. Treasury bonds, while also pursuing a high yield with low-risk. Smart Saver invests your money in a U.S. Short-Term Treasury Bond ETF, called SHV, as well as a U.S. Short-Term Investment Grade Bond ETF, called NEAR. SHV is the tax-advantaged componen, while the NEAR portion of the portfolio helps Smart Saver seek a higher yield. So, most earnings will be tax-advantaged.

If you haven’t yet, give our calculator a try to see Smart Saver’s potential tax advantages. Note that you have to log into a personal Google Account to use the calculator.

Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.

Contributing Authors

Jamie Cartwright
Content Marketing Manager, Betterment

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