Soaring interest rates have rekindled Americans’ penchant for fixed-income investments like bonds and money market funds, but experts warn that they should be prepared for the taxes.
To battle inflation, the Federal Reserve has raised its benchmark, short-term fed funds rate to target 5.25%-5.50%, from near zero at the start of 2022 and to the highest level in 22 years.
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.
Learn more: Best current CD rates
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.
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.”
Yes, consider what you’re buying and where you’re holding the assets.
“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.
For the risk averse:Best low-risk investments of 2023
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.”
Not every fixed-income asset is the same so you must do your homework. For example:
Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at[email protected] and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday.
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