Taxes on Savings are Unfair, Here’s How to Fix It

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Taxes on savings accounts are unfair. To illustrate what I mean, let’s say a young family of four lives in a two-bedroom apartment that they have outgrown. Both adults have decent jobs and are pulling in $80,000 between the two of them. They decide that they want to start saving for a home of their own where their kids can grow up. They know that it will take a couple of years before they have enough for the down payment. They smartly put their money into a high-yield savings account, earning 2% interest, this helps them earn a little extra income while not risking their investment in the stock market. Their goal is to save up for a 20% down payment. After three years of saving every extra penny, they have $50,000 in the account.

Because their savings are in a high-yield savings account with 2% interest, they earn $1,000 a year. Unfortunately, inflation for the last few years has been averaging 2.5%. Inflation is the average increase in the cost of goods over the past year. To illustrate inflation, assume the same home that they could have purchased for $250,000 last year now will cost them $256,250. Sadly, the family is also losing money because they will have to pay tax on the $1,000 of interest they earned from their savings. Taxation on interest income is the same as the couple’s income tax level, which in 2019, is 22% for a couple earning $80,000, meaning they would owe $220. Not only is the house they were trying to purchase now more expensive, but they lost almost a quarter of their interest to taxation.

Sixty percent of Americans, an unbelievable number, do not have $1,000 in savings should an emergency arise. This may be partially due to the design of our taxation system, which encourages people to not save. In times when inflation is high, even the highest earning interest savings accounts can’t keep up with inflation. With the costs of products getting more expensive and the buying power of your account becoming less, saving money just doesn’t make sense. To make matters worse, what little you do save comes with a tax. For the most part, taxes on investment income is good. If a person buys a bunch of stock and it goes up 50% in a few years, that person should pay tax on that gain, but how do we decide what investment income to tax?

There have been some proposals put forward over the years to change how investment income is taxed. When the Reagan Administration pushed the famous 1986 tax reform, they briefly thought about allowing Americans to deduct for inflation on all their investments. However, the total cost shocked the Reagan Administration and they quickly abandoned the idea. The number was so high because wealthy Americans often don’t pay income tax as most of us do, instead they get the majority of their income through investments. Stock incentives, taxed at the much lower capital gains rate, are how many wealthy Americans are paid. If you allow everyone to deduct the increase in inflation from their investment income, you’d be benefiting the rich far more than the rest of Americans.

My proposal is to allow a deduction for the first $1,000 of interest income from a savings account. This would allow my example family at the beginning of this article to save their $50,000 for the down payment of their home and not have to pay taxes on their interest income. It would also decrease the disincentive for Americans to maintain savings, and would not be a huge benefit to the super rich. If politicians are concerned that it would lower the income to the U.S. Treasury too much, they could limit the deduction to families making less than $100,000 annually.

If politicians were still concerned that this change in policy would increase the deficit, they could increase the capital gains rate a few hundredths of a percent to make it slightly more equitable to Americans paying income tax. For example, the couple from the example who are saving for their house would have to pay 22% of the $1,000 of interest in taxes. However, let’s say a billionaire cashes out on $100 million of investments to buy a new yacht, the billionaire would be paying long-term capital gains, which is taxed at the… 20% capital gains rate. What kind of system do we have where Americans saving for a house pay higher taxes than billionaires paying for a yacht?

With the setup of our current tax system, it’s pretty dumb to have money sitting in a bank account. The money sitting in your bank account is losing buying power because of inflation and yearly taxes, which doesn’t happen for investments in the stock market. If you want to beat inflation you should put your money in the stock market, but the stock market is a dangerous place for your savings if you need to use the money in the next 3–5 years. The stock market is prone to huge swings and if you’re looking to buy a house, or any other large purchase in the next few years, you should probably keep your money in a safer investment, such as a high-yield savings account. However, don’t keep your money in the savings account too long, it’s probably decreasing in value because of inflation and tax. This balancing act is why so many Americans struggle to invest.

I hope that Congress will fix this problem in the near future. Maybe these issues will be addressed in future middle-class tax cuts, but there were tax cuts at the end of 2017 and this issue was not touched. So for now, try to balance your savings between stocks and less risky investments like savings accounts, certified deposits (CDs), and bonds. Maybe the balance between stocks and savings account will even out to beat back inflation but also insulate your savings from big losses in the stock market. If you do open an account for stocks, I suggest trying to open an account with low fees, like Vanguard or Fidelity. I also wrote about the struggle between finding the right way to invest here:

Reality is merely an illusion, albeit a very persistent one. — Albert Einstein

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