As the old saying goes, there’s no sure thing in life but death and taxes, but not everything you do is taxable. Many Americans earn hundreds of dollars each year from the cash back rewards on their credit cards, so they are careful to consider if they will owe taxes on this amount.
How the IRS looks at credit card rewards
When you earn rewards from your credit card in the form of points, miles or cash back, you are receiving something of value in exchange for your purchase. At most, you might be able to receive as much as 6% cash back from a credit card like the American Express Blue Cash Preferred, which offers 6% cash back on up to $6,000 spent at US supermarkets each calendar year.
Nevertheless, the 6% cash back that you receive is not actually income, since you are still taking a loss of 94% on that purchase. Essentially, any cash back you receive is considered to be a discount on a purchase, not actual taxable income. To understand why, it can help to consider this example. If you use a coupon for $20 off your purchase of a new television, you will not have to report the $20 that you save as income. And if you pay $1,000 for a television using a credit card that offers 2% cash back, you will also save $20, which you will not have to report as income.
This is also consistent with how the IRS treats other forms of credit card rewards such as frequent flyer miles. In short, the IRS does not tax frequent flyer miles. In fact, it went so far as to issue an official memo saying so in 2002. IRS Announcement 2002-18 says:
“Consistent with prior practice, the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel. Any future guidance on the taxability of these benefits will be applied prospectively. “
When bank rewards can be taxable
One reason some people may think their cash back credit card rewards may be taxable is because there are some types of bank rewards that are subject to taxation. When banks offer bonuses for opening a new checking, savings or investment account, they will typically issue a 1099 form to account holders. The thinking here is that customers are receiving actual income from the bank, without making a purchase. Depositors will place money into their account to qualify for the sign-up bonus, but this money remains theirs and can be returned, so it’s not a purchase. So be it a toaster, some frequent flyer miles, or several hundred dollars in cash back, you can expect a 1099 form from your bank if you received some sort of bonus when you opened up a deposit account. On the other hand, credit card sign up bonuses have never been taxable.
What this means for cash back credit card users
Since the IRS considers your cash back credit card reward to be simply a savings, what does that mean? There is another popular expression that says a penny saved is a penny earned. Yet it practice, this is not necessarily true. I would argue that a penny saved is worth more than a penny earned, because a penny earned is subject to taxes while a penny saved is not.
So if you were able to carefully manage your reward credit card portfolio, and earn a net total of $200, this benefit would not be taxable. Yet if chose to spend your time and energy at your job earning an additional $200, you would have a to pay taxes on that amount. Since cash back credit card rewards are not taxable, you can consider this money to be tax free “income” even if the IRS doesn’t. Just be sure to never make an unnecessary purchase in order to earn rewards, as you will always come out behind in the end.
Ways to earn the most cash back
Rather than try to choose between cards that offer the most cash back on all purchases for those that offer higher levels for some purchases, consider carrying multiple cash back cards for different types of purchases. Also, consider applying for a card that offers a valuable signup bonus to new applicants. And as with all reward cards, keep in mind that cash back credit cards will usually have a higher standard interest rate than similar cards that don’t offer rewards. Therefore, those who carry a balance on their credit cards should forgo rewards and focus on finding a card with the lowest possible interest rate.
With a cash back credit card, it can feel like you are earning money, but thankfully, the IRS doesn’t see it that way.