Filing tax returns over bank account-related interests

Question

I do know that in the US, bank-account interests are taxable as passive incomes, but what I don't understand is the point of filing tax returns on bank account interests, since the government (or the IRS), or whatever, has access to bank accounts and can directly deduct taxes (not seizing, I'm not talking about unpaid taxes or fraud istances), without henceforth requiring a tax return filing, since they could deduct the money themselves.

Answer 1

A US citizen or recipient of US-generated income must file a US tax return if that person has been paid or received "income" more than a specified amount. (Specifying what is meant by any of these terms (i.e., "recipient," "US-generated income," "income," and "specified amount" varies considerably, is addressed by multiple IRS publications, and is beyond the scope of a general answer.)

Bank account interest is income. A return must be filed if the various conditions as to income are met. The conditions are set by the United States Code, as interpreted by the Rules adopted by the Department of Internal Revenue. Bank account interest was deemed to be "income" as a political decision made by the Congress, which enacted the Internal Revenue Code.

I am not a tax expert. As I observed in my Answer and Comments to your previous question on this subject, it is clear that the IRS can seize individual bank accounts pursuant to warrants of execution issued by state and federal courts. I believe, in addition, that it is possible that the IRS can unilaterally take similar against individual accounts. However, I have never heard of it doing so in cases of mere non-payment or without signifiant, multiple notices to the taxpayer. Such seizure seems only to occur in cases of tax resistance or tax avoidance, or persistant non-response by the taxpayer.

Why the IRS might (or might not) act in this manner might be explained by the IRS' desire to minimize doing things which many citizens and taxpayers might find immoral or politically unacceptable. Remember, the US tax system depends on voluntary participation by taxpayers. Proportionally few audits are actually conducted.

Beyond that, and whatever budgetary considerations might constrain IRS actions, your guess is as good as mine.

Answer 2

US banks do report interest to the IRS. But the amount of tax on the interest cannot be computed solely on the basis of the amount of interest paid by the bank. The person's taxes depend on factors such as whether the person is married, blind, how many dependents the person has. The tax also depends on the person's total income, some of which is only reported by the person when the annual tax return is filed. For example, the person may run a retail business and receive many small payments, which are not reported by the payers to the IRS.

In short, the IRS does not automatically deduct the tax on interest from the account because the IRS is unable to compute what the tax should be.

Answer 3

The point of withholding, it should be noted, is not to prevent taxpayers from having to file tax returns. The exact tax liability for the year cannot be known until the year is over. Even if there were withholding on bank interest, taxpayers would still have to file returns to establish the final amount of the tax liability, which usually leaves them with a refund check or a tax bill.

The point of withholding, rather, is to have roughly the right amount of tax paid to the Treasury over the course of the year rather than all at once when the tax return is submitted. This helps with treasury's cash flow, of course, but it also helps the taxpayers' cash flow, because it relieves them of the need to ensure that they're saving enough cash to pay a huge annual tax bill. That in turn helps the treasury's cash flow indirectly, and allows the IRS to save on collection efforts.

Bank interest is generally of such a small magnitude that it doesn't affect the total amount of the tax bill by very much at all. Therefore, any system to require withholding of such interest will have a greater cost than benefit. (Some foreign account holders are in fact subject to withholding on bank interest.)

People whose income tax withholding is not adequate (or is nonexistent) may be required to make estimated tax payments to supplement the withholding. Someone who has so much money in the bank that their interest income is very large will have to make these payments, but such people will be rare.

Actual cases in which estimated tax payments are common include large sources of unearned income (often not subject to withholding), which includes retirement income, and non-employee earned income (that is, someone who is paid as a contractor using form 1099).