Even though the fondness of American citizens for fixed-income investments such
as money market funds and bonds has been revived by soaring interest rates, experts have warned that they must be ready for the taxes.
High interest rates fixed income investments effect
Short-term fed funds have been raised by the Federal Reserve to target 5.25% to 5.50%
to combat inflation from near zero at the beginning of 2022 to the optimum level in as many as 22 years.
The spenders have been hurt by the higher rates although it is a blessing for the sellers,
particularly when the stock market is volatile and the economy is uncertain.
For example, money market fund assets increased to as many as $5.69 trillion during the initial 3 months of 2023, revealed by Fed data.
Rob Keller, who happens to be a tax partner at KPMG, asserted that although it is a
positive sign that you are receiving higher interest, the question is whether you are
prepared for a tax hit in April or before that, in case you need to make quarterly payments.
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What do you mean by fixed-income investments?
We can define fixed-income assets as those with a fixed and regular payment like money market funds and savings accounts.
We use them for offsetting stock holdings in a balanced portfolio that generates returns in most cases by appreciating in value.
A conventional balanced portfolio comprises 40% fixed income as well as 60% stocks.
How can you compare fixed-income investments with stocks?
We count money that is generated from fixed-income assets as income and it will be taxed at the income tax rate, whichever group you are falling into.
This year, the IRS has listed 7 federal income tax rates that range from 10% to 37%.
Qualified capital gains tax rates and stock dividends held for a minimum of one year
vary from 0% to 20% which will depend on filling status and taxable income.
The majority of the individuals pay a 15% capital gains tax when selling their stock as reported by the IRS.
It is possible for fixed-income payments to be subject to state taxes as well.
It can be particularly bad in case you happen to be in a high-income tax state.
Qureshi said that approximately 50% of your interest income will go back to the
government in case you happen to be in a high-tax group and even though 5.5%
interest might seem to be good on your money on the surface, you need to give back 50% which is not that good.
Is it possible to minimize the tax blow?
Yes, take into consideration what you are purchasing and where the assets are held by you.
It might be feasible for you to escape state tax in case you invest in a security backed by the US government such as a T-bill, bond, or note.
• Municipal bonds which have been issued by city, state, and local governments are usually exempted from federal taxes.
Moreover, they are generally free from state tax although there might be some exceptions.
• Make it a point to make investments in fixed-income assets by means of your non-taxable retirement accounts.
Apart from enabling you to skip taxes, it will also control once you like to take the cash and pay taxes.
Are fixed-income investments worthy in case we consider the tax hit?
Yes. It is likely that you will come out ahead in spite of the tax hit although not by as much as expected by you.
Keller asserted that it is still possible for you to generate cash in spite of being taxed.
Obtaining 5.5% interest is a positive sign for the majority of the taxpayers, he added.
What else should be known regarding fixed-income investments?
It is imperative for you to do your homework since all fixed-income assets will not be the same. For instance:
• It is not easy to sell municipal bonds as Treasuries in case you like to dump them.
• Treasuries will be the safest since they have been 100% assured by Uncle Sam.
Therefore, it would always be possible for you to obtain your initial investment.
However, you might lose your investment since money market funds are not guaranteed.
• It is imperative to purchase Treasuries from the government directly although it is possible to purchase CDs at credit unions, banks, and brokerages.
Although it is possible to purchase CDs more easily than Treasuries, CDs need close supervision.