- The advertised rate is not what you earn — the APY is, and it depends entirely on how often interest is credited.
- Savings interest is ordinary income, taxed at your full marginal bracket in the year it is earned, plus state tax where it applies.
- Money deposited early earns for longer, so the timing of contributions matters more than small differences in rate.
- Chasing an extra tenth of a percentage point between banks is usually worth more than chasing a better compounding schedule.
How savings interest works
A savings account pays interest on whatever balance it holds, credited on a schedule the bank sets — daily, monthly, quarterly or annually. Each time interest is credited it joins the balance, so the next credit is calculated on a slightly larger number. That is the whole mechanism, and over a long enough period it is the difference between an account that keeps up with inflation and one that does not.
The rate on the poster is the nominal annual rate. What you actually earn over a year is the annual percentage yield, and it is higher than the nominal rate whenever interest is credited more often than once a year. Banks are required to disclose APY under Regulation DD for exactly this reason: it is the only figure on which two accounts are directly comparable.
Deposits change the shape of the result more than the rate does at ordinary balances. A regular monthly transfer earns interest for every month it has been in the account, so money added early does most of the work — the same total contributed over ten years earns meaningfully less if it all arrives in year nine.
The math
The annual percentage yield comes from the standard conversion: APY = (1 + r/n)^n − 1, where r is the quoted annual rate as a decimal and n is the number of times a year interest is credited. At n = 1 the two are identical; at n = 365 a 5% quoted rate becomes about 5.127%.
The projection applies your deposit or withdrawal every month and grows the balance by the compounding periods that fall in that month, then rolls the twelve months into the year row shown below. Applying deposits monthly regardless of the compounding schedule is deliberate: a payroll transfer does not wait for the bank's quarterly compounding date, and modelling it as though it did would understate the result.
Tax is applied to each year's interest at the marginal rate you set and reported separately rather than taken out of the balance. Savings interest is ordinary income in the year it is earned — no long-term capital-gains rate applies, and your bank issues a Form 1099-INT for $10 or more — so your marginal bracket, plus any state income tax, is the right rate to enter.
Worked example
Put $10,000 into an account paying 4% compounded monthly and add $300 a month. After ten years the balance is about $58,000: roughly $46,000 of your own money and roughly $12,000 of interest. The yield is 4.074%, not 4% — three quarters of a percentage point of extra earnings over the decade, purely from the compounding schedule.
Now apply a 32% marginal rate to that interest. The account still holds $58,000, but about $3,800 of the interest is owed in federal tax, leaving roughly $8,200 kept — before state tax, which in a high-tax state can take a further tenth. That after-tax figure is what a taxable savings account should be compared on, and most savings calculators do not show it at all.
Key terms
- Nominal rate (APR)
- The annual rate a bank advertises, before accounting for how often it credits interest. Two accounts quoting the same nominal rate can pay different amounts.
- Annual percentage yield (APY)
- What a nominal rate actually pays over a full year once compounding is included. Banks must disclose it under Regulation DD, and it is the only rate on which accounts are comparable.
- Compounding frequency
- How often the bank credits interest to the balance — daily, monthly, quarterly or annually. More often means a higher APY at the same nominal rate.
- Marginal tax rate
- The rate charged on your next dollar of income, which is the rate that applies to savings interest. Not your effective rate, which is lower.