Rising interest rates have made many Americans interested in safer investments like bonds and money market funds. But experts are warning that there’s a catch – taxes.
To fight inflation, the Federal Reserve has increased its short-term interest rate to a level not seen in 22 years, now targeting between 5.25% and 5.50%. While this is good news for savers who can earn more on their money, it might lead to a higher tax bill in the upcoming year.
The income you earn from these safer investments is considered regular income and is taxed based on your income tax rate, which can be as high as 37% in 2023. This is typically higher than the tax rates for dividends and capital gains from stocks, which can be as low as 0% for some people and 15% for most.
Additionally, you might also have to pay state taxes on your fixed-income earnings, especially if you live in a high-tax state like California or New York, where rates can go above 10%. This means that a significant portion of your interest income could end up going back to the government.
So, while earning 5.5% interest on your money might sound good at first, you could end up losing a substantial chunk of it to taxes if you’re in a high tax bracket.
It’s essential to be aware of the tax implications when considering fixed-income investments. Not all of these investments are the same. Here are some key points to keep in mind:
- Safety: Treasury bonds are the safest option because they are backed by the government, ensuring you’ll get your initial investment back. Money market funds, on the other hand, are not guaranteed or FDIC insured, so you could potentially lose your entire investment. Money market accounts and Certificates of Deposit (CDs) are typically FDIC insured up to $250,000.
- Liquidity: Municipal bonds may not be as easy to sell as Treasuries since they are issued in smaller amounts.
- CD Management: CDs are easier to buy than Treasuries, but you need to manage them carefully. The interest rate you lock in for a CD only applies for the CD’s term. If it rolls over automatically, it might do so at a lower rate. If you cash it out early, there could be fees. In contrast, there are no fees to cash out a Treasury bond.
In conclusion, while fixed-income investments can offer stability and income, it’s important to consider the potential tax implications and choose the right investment option based on your financial situation and goals.