Many investors are likely to see the recent 5% (or higher) yields in short-term instruments like CDs and Money Market funds as too good to pass up. With interest rates near zero for such an extended period of time, the past 12 months have been a “gold-rush” of sorts into interest-bearing securities.
However, as with any increases in expected returns, especially in the form of interest or dividends, investors should consider the potential for an increase in taxes due.
A recent Wall Street Journal article outlined these potential risks, so let’s summarize some of the information from the article as well as giving our own thoughts on the topic.
First, in general, interest income from checking/savings, Certificates of Deposit (CDs), and other interest-bearing investments is taxed at ordinary rates. This means that if a person in a 30% tax bracket invested $100,000 in a CD in a taxable account that had a yield of 4%, the $4,000 of income earned would be taxed at 30%. This results in an approximately $1,200 bill from Uncle Sam. While we know that this is often the price of higher income, it’s not always expected, and rarely welcomed.
Second, an increase in adjusted gross income (AGI) can have impacts beyond the taxes owed to the IRS. For example, Medicare-age individuals could face increases in Part B premiums. For higher-earning individuals, this could mean facing the 3.8% net investment income tax that applies when AGI is above $200,000 (single)/$250,000 (joint).
Third, let’s look at the individual investments and their nuances:
- Certificates of Deposit (CDs): Interest earned is taxed at ordinary income rates at federal and state levels, typically in the year interest is earned.
- Money Market Funds: There are taxable and tax-free money market funds. Interest on taxable money markets is generally taxed at federal and state levels. You may want to consider tax-free money markets in the case of higher tax brackets. Running a Taxable-Equivalent Yield calculation to compare yields between taxable and tax-free funds, as well as discussing with a tax professional is generally recommended before taking action.
- Treasury Bills/Notes: Treasuries are generally exempt from state and local taxes. Federal taxes are charged on interest payments. While STRIPS (Separate Trading of Registered Interest and Principal Securities) and TIPS (Treasury Inflation-Protected Securities) can be subject to phantom income tax (taxed on income earned yet not received), interest on T-bills and bonds should be taxed similarly to the above investments.
- Series I Savings Bonds: No state or local taxes. Generally, no federal taxes are due until bonds are cashed in. If proceeds are used to pay for higher education, part or all of interest can be exempt from federal taxation.
- Municipal Bonds: Always federal income-tax free and exempt from state taxes in the state of issue.
Finally, let’s look at a few ways in which we can help:
- This blog. We take time to educate our clients and their loved ones on potential issues that may not always be front-of-mind.
- Asset location. It’s not all about the allocation, but also where certain types of investments are located (taxable or tax-deferred accounts). We can consider utilizing high interest/dividend strategies in tax-qualified accounts and leaving more tax-efficient investments in taxable accounts.
- For those of you who already have earned higher levels of interest in taxable accounts than in previous years, we can work with your tax professional to find ways in which AGI can be offset. This can include increasing deferrals into their employer-sponsored retirement plan, maximizing deductible contributions to Traditional IRAs, Health Savings Accounts (HSA) contributions, or reducing or eliminating other forms of investment income like capital gains by harvesting losses against anticipated gains.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.
CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity, whereas investing in securities is subject to market risk including loss of principal.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.
Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions, and it may not achieve its investment objective.
All illustrations are hypothetical examples and are not representative of any specific situation.
Northeast Planning Associates, Inc. and LPL Financial are not affiliated with any other referenced entity.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
Tax services are not offered by Northeast Planning Associates, Inc., LPL Financial or affiliated advisors. Clients should consult with their personal tax advisors regarding the tax consequences of investing.