Rising interest rates have revived Americans’ penchant for fixed-income investments such as bonds and money market funds, but experts warn of the need to prepare for taxes.
To combat inflation, the Fed raised its benchmark short-term federal funds rate to target 5.25%-5.50%, from near zero at the start of 2022 and to the highest level in 22 years.
High interest rates hurt spenders who have to pay more to borrow, but they are a boon to savers who get a higher return on their money, especially with economic uncertainty and stock market volatility. For example, money market fund assets rose to a record high, where they peaked $5.69 trillion Federal Reserve data for the first three months of this year shows.
However, this high, steady, nearly risk-free income may come at a price: Come the new year, you may find yourself with a larger tax bill, experts say.
“On the one hand, it’s great news, you’re getting higher interest, but are you prepared for a tax hit in April or before, if you have to make estimated quarterly payments?” said Rob Keller, tax partner at tax consulting firm KPMG.
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What are fixed income investments?
Fixed-income assets are those that have regular, fixed returns such as savings accounts, money market funds, certificates of deposits (CDs), or government and municipal bonds. They are generally low-risk income generators.
In a balanced portfolio, they are used to offset stock holdings, which are riskier and mostly generate returns through appreciation in value. A traditional balanced portfolio consists of 60% stocks and 40% fixed income, also known as a 60/40 portfolio.
How are fixed income investments taxed compared to stocks?
Money generated from fixed income assets is counted as income and is taxed at your income tax rate, whichever bracket you fall into. In 2023, the IRS lists Seven federal income tax rates Ranging from 10% to 37%.
“These are typically higher than the rates of dividends and capital gains from stocks,” said Omar Qureshi, investment strategist at Hightower Wealth Advisor in St. Louis, Missouri.
Qualifying dividends and capital gains tax rates for assets held for at least one year range from 0% to 20%, depending on taxable income and filing status. Most people pay a 15% capital gains tax when they sell their stocks says the IRS.
Fixed income payments may also be subject to state taxes. This could be especially bad if you’re in a state with high income taxes like California or New York, both of which have top tax rates above 10%, advisors said.
“If you belong to a high tax bracket, about 50% of your interest income goes back to the government,” Qureshi said. “On the surface, 5.5% interest on your money sounds good, but if you have to give half of it back, it’s not good.”
Is there a way to minimize the tax hit?
Yes, think about what you buy and where you keep the assets.
- If you invest in U.S. government-backed securities such as Treasuries, securities, or bonds, you can escape state tax.
“You’ll still pay federal tax on interest income, but if you live in a high-tax state like California, a Treasury bill can be a great investment because you can save on the state side of the house,” Keller said.
- Municipal bonds, issued by state, city and local governments, are generally free of federal taxes as well. They are also usually exempt from state tax in the state in which the bonds were issued, but there are exceptions, so advisors say to tread carefully and check with an advisor about the rules regarding the municipal bonds you are considering.
- Invest in fixed income assets through non-taxable retirement accounts. This will not only allow you to skip taxes now, but control when you want to get the money and pay taxes, said J.R. Gondek, managing director and partner at wealth management firm Lerner Group.
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Are fixed income investments worth it, considering the tax hit?
Yes. Despite the tax hit, you’ll likely still come out ahead even if not as much as you expected, advisers say.
“Even if you pay taxes, you still make money,” Keller said. Also, “For many taxpayers, getting 5.5% interest is a good thing. “Not all taxpayers pay the highest marginal rate (income tax), and they may live in a state like Texas with no (income) tax.”
What should I know about fixed income investments?
Not all fixed income assets are the same, so you should do your homework. For example:
- Treasury bills are the safest because they are 100% guaranteed by Uncle Sam so you can always get your initial investment back, but money market funds are neither guaranteed nor insured by the FDIC, which means you could lose your entire investment. However, money market accounts and CDs are FDIC insured up to $250,000.
- Municipal bonds like Treasury bonds are not as easy to sell if you want to get rid of them because they are issued in much smaller quantities.
- While buying CDs is easier than buying Treasuries — Treasuries must be purchased directly from the government but CDs can be purchased from banks, credit unions, and brokerage firms — CDs require close management. The price you lock in to a CD is only for the duration of the CD. If the CD scrolls automatically, it may do so less frequently. Or if you cash it out early, there may be a fee. There are no fees for cashing out the treasury.
Medora Lee is the money, markets and personal finance correspondent at USA TODAY. You can access it atmjlee@usatoday.com And sign up for our free Daily Money newsletter for personal finance tips and business news every Monday.
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