You cannot avoid tax on savings interest, but you can reduce what you owe

Interest earned in a savings account is taxable income to the IRS, and you will report it on your tax return. There is no legal way to make that interest disappear from your tax bill. What you can do is move money into accounts or investments that generate interest that is taxed at a lower rate, or that is not taxed at all — and the strategy that works depends on how much money you have and what you plan to do with it.

The most straightforward approach is to use a Roth IRA or Roth 401(k), where interest and investment gains grow tax-free and you pay no tax when you withdraw the money in retirement. If you do not have access to a Roth account through your employer, a Roth IRA has a contribution limit of $7,000 per year (as of 2024, though this changes annually), and you must have earned income to open one. For money you need to access before retirement, municipal bonds generate interest that is exempt from federal tax, though you will still owe state tax in most cases.

Key Takeaways

  • Savings account interest is always taxable income, but you can shift money into tax-advantaged accounts like Roth IRAs or Roth 401(k)s where the interest grows tax-free.
  • Municipal bonds produce interest that is exempt from federal income tax, making them useful for taxable savings outside retirement accounts.
  • High-yield savings accounts in regular taxable accounts do not reduce your tax burden — they just pay more interest, which means more tax owed.
  • If your total interest income falls below $600 per year, you may not receive a Form 1099-INT, but you still owe tax on that interest.
  • Treasury bonds and I Bonds are exempt from state and local tax, which can matter significantly if you live in a high-tax state.

Tax-free growth in retirement accounts

A Roth IRA is the simplest tool for most people. You contribute money that has already been taxed (you do not get a deduction), and then all interest, dividends, and investment gains grow tax-free. When you withdraw the money in retirement — age 59½ or later — you owe no tax on any of it. The catch is that you can only contribute $7,000 per year if you are under 50, or $8,000 if you are 50 or older (2024 limits). You must have earned income from a job or self-employment to open one, and there are income limits: if you earn more than roughly $146,000 as a single filer or $230,000 as a married couple filing jointly, you cannot contribute directly to a Roth (though you may be able to use a "backdoor Roth" strategy, which involves converting a traditional IRA).

If your employer offers a Roth 401(k), you can contribute much more — up to $23,500 per year in 2024, or $31,000 if you are 50 or older. The rules are the same: you contribute after-tax dollars, and withdrawals in retirement are tax-free. Not all employers offer this option, so check with your HR department. A regular 401(k) does not give you the same benefit — contributions are tax-deductible now, but you pay tax on withdrawals later.

Municipal bonds and tax-exempt interest

If you have money outside a retirement account that you need to access before retirement, municipal bonds (often called "munis") pay interest that is exempt from federal income tax. You buy a bond issued by a state, city, or local government, hold it until maturity, and collect interest payments that the IRS does not tax. The tradeoff is that municipal bonds typically pay lower interest rates than taxable bonds, so the tax savings has to outweigh the lower yield.

Municipal bonds are usually exempt from federal tax but not state tax, unless you buy a bond issued by your own state. If you live in California and buy a California municipal bond, you avoid both federal and state tax on the interest. If you buy a bond from another state, you still owe state tax on the interest. This matters most if you live in a high-tax state like California, New York, or Massachusetts. You can buy municipal bonds through a brokerage account, and they come in different maturities — some mature in a few years, others in 20 or 30 years.

Treasury bonds and I Bonds exempt from state tax

Treasury bonds, Treasury notes, and Treasury bills are issued by the federal government and generate interest that is exempt from state and local income tax — you still owe federal tax, but not state tax. This is useful if you live in a state with high income tax and want to keep some money in a liquid, safe investment. You can buy Treasuries directly from the U.S. Treasury at TreasuryDirect.gov with no fees, or through a brokerage.

I Bonds (Series I Savings Bonds) are another federal option. They pay interest that is exempt from state and local tax, and if you use the money for education expenses, the interest can be completely exempt from federal tax as well. I Bonds have a minimum holding period of one year, and if you cash them in before five years, you lose the last three months of interest as a penalty. The interest rate adjusts every six months based on inflation, so they are useful if you are concerned about rising prices eroding your savings.

Why high-yield savings accounts do not reduce your tax bill

A high-yield savings account pays more interest than a regular savings account — sometimes 4% or 5% annually, compared to 0.01% at a traditional bank. But that higher interest is still fully taxable. If you earn $5,000 in interest at a high-yield account, you owe tax on all $5,000, just as you would at any other savings account. The only advantage is that you earn more money before taxes; the tax burden itself does not shrink. High-yield accounts are useful if you want to maximize the interest you earn on money you need to keep accessible, but they are not a tax strategy.

The same is true for money market accounts and certificates of deposit (CDs). All of the interest is taxable income. The only way to reduce your tax is to move the money into an account or investment where the interest itself is tax-exempt or tax-deferred.

Reporting interest under $600 and the Form 1099-INT

If your total interest income from all sources is less than $600 in a year, your bank or financial institution is not required to send you a Form 1099-INT. However, you are still required to report that interest on your tax return, even if you do not receive the form. The IRS tracks interest income through other means, and failing to report it can trigger an audit or penalty.

If your interest income is $600 or more, you will receive a 1099-INT by January 31 of the following year. The form shows the total interest paid to you during the year. You report this amount on your tax return — usually on Schedule B if you have other investment income, or directly on Form 1040 if interest is your only investment income. Keep a copy of the 1099-INT with your tax records.

Strategies for different amounts of savings

If you have less than $7,000 in savings, a Roth IRA is the best option if you have earned income. You can contribute up to $7,000 per year, and all interest grows tax-free. This works whether you have $1,000 or $7,000 to start with.

If you have $7,000 to $50,000 in savings, you can max out a Roth IRA and put the rest into municipal bonds or Treasury bonds, depending on your state's tax rate. If you live in a high-tax state, municipal bonds or Treasury bonds make more sense. If you live in a low-tax state, the federal tax savings from municipal bonds may not be worth the lower interest rate.

If you have more than $50,000, you have room for a Roth IRA, a Roth 401(k) if your employer offers one, and a mix of municipal bonds and Treasury investments for the remainder. The exact mix depends on when you need the money and your tax bracket.

Frequently Asked Questions

Do I have to pay tax on interest if I do not spend it?

Yes. Tax is owed on interest income in the year it is earned, whether you withdraw it, reinvest it, or leave it sitting in the account. The IRS considers it income as soon as the bank credits it to your account.

Can I move money between savings accounts to avoid reporting interest?

No. Moving money does not create new income or erase existing income. The interest you earned is still taxable, regardless of which account holds the money now. The bank reports interest based on the account where it was earned.

What if I have a joint savings account with my spouse?

The interest is split between you based on who owns what portion of the account. If you each own half, you each report half the interest. The bank will issue separate 1099-INT forms or split the interest on one form, depending on how the account is set up. Confirm the ownership split with your bank before tax time.

Are savings bonds different from Treasury bonds for tax purposes?

Yes. Series EE Savings Bonds and I Bonds are exempt from state and local tax but subject to federal tax. Treasury bonds, notes, and bills are also exempt from state and local tax. However, I Bonds have special rules: if used for education, the interest can be completely exempt from federal tax as well, and you cannot cash them in for one year.

If I move money to a Roth IRA, do I owe tax on the interest that was already earned?

No. You contribute money that has already been taxed (or will be taxed as income in the year you earn it). Once the money is in the Roth, all future interest and gains are tax-free. You do not owe tax on interest earned before you opened the account.