Higher rates hurt spenders who must pay more to borrow but are a boon to savers who receive a higher return on their money, especially with the economy uncertain and the stock market volatile. Money market fund assets, for example, grew to a record, topping $5.69 trillion in the first three months of this year, Fed data show.
That higher, steady and nearly riskless income may come with a price though: 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 ready for a tax hit in April or sooner, if you have to make quarterly estimated payments?” said Rob Keller, tax partner at tax advisory firm KPMG.
What are fixed-income investments?
Fixed-income assets are those with a regular, fixed payout 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’re used to offset stock holdings, which are riskier and mostly generate returns by appreciating in value. A traditional balanced portfolio consists of 60% stocks and 40% fixed income, also known as the 60/40 portfolio.
How are fixed-income investments taxed compared with stocks?
Money generated from fixed-income assets is counted as income and 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%.
“Those are typically higher than dividends and capital gains rates from stocks,” said Omar Qureshi, investment strategist at wealth advisor Hightower in St. Louis, Mo.
Qualified stock dividend and capital gains tax rates for assets held at least a year range from 0% to 20%, depending on taxable income and filing status. Most people pay a capital gains tax of 15% when they sell their stock, the IRS says.
Fixed income payments also may be subject to state taxes. This can be especially bad if you’re in a high income-tax state like California or New York, which both have top rates above 10%, advisors said.
“If you’re in 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 so good.”
Is there any way to lessen the tax blow?
Yes, consider what you’re buying and where you’re holding the assets.
- If you invest in a U.S. government-backed security like a T-bill, note or bond, you can escape state tax.
“You’ll still pay federal tax on the interest income, but if you live in a high tax state like California, a T-bill could 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 from federal taxes, too. They’re also usually free from state tax in the state where the bond was issued, but there are exceptions, so advisors say tread cautiously and check with an advisor about rules on the municipal bonds you’re considering.
- Invest in fixed-income assets through your nontaxable retirement accounts. This will not only allow you to skip taxes now but control when you want to take the money and pay taxes, said JR Gondeck, managing director and partner at the Lerner Group wealth management firm.
Are fixed-income investments worth it, considering the tax hit?
Yes. Despite the tax hit, you’re likely to still come out ahead even if not by as much as you had expected, advisors say.
“Even if you’re paying tax, you’re still making money,” Keller said. Also, “for lots of taxpayers, getting 5.5% interest is good. Not every taxpayer pays the highest marginal (income tax) rate and maybe, they live in a state like Texas with no (income) tax.”
What else should I know about fixed-income investments?
Not every fixed-income asset is the same so you must do your homework. For example:
- Treasuries are safest because they’re 100% guaranteed by Uncle Sam so you can always get your initial investment back, but money market funds are neither guaranteed nor FDIC insured, meaning you can lose your entire investment. Money market accounts and CDs, though, are FDIC insured up to $250,000.
- Municipal bonds aren’t as easy to sell as Treasuries if you want to dump them because they’re issued in much smaller amounts.
- While CDs are easier to buy than Treasuries − Treasuries must be bought directly from the government but CDs can be bought at banks, credit unions and brokerages − CDs require close management. The rate you lock in for the CD is only for the term of the CD. If the CD automatically rolls over, it may do so at a lower rate. Or if you cash it out early, there may be fees. There are no fees to cash out a Treasury.