Enjoying Higher Yields

Investors are enjoying higher yields from even the most mundane investments. The Federal Reserve’s rate-hiking campaign has lifted the yield on a range of assets. Select 1-year certificates of deposit are paying annual percentage yields exceeding 5%, as are money market funds. Even idle cash in some online savings accounts is growing to the tune of at least 4% APY these days.

Tax Implications

However, these higher yields could present investors with an interesting problem come tax time next spring. This investment income is reportable to the Internal Revenue Service and is subject to taxes. The interest you receive on CDs or your savings account is taxed as ordinary income – a rate that’s higher than the levies applicable to capital gains, and which can be as high as 37%.

“Don’t look at this as a negative necessarily,” said Tim Steffen, CPA and director of advanced planning at Baird. “Think of it as a positive: Taxes are something you have to deal with, but the only way to really avoid the tax is not to have the income.”

Plan Ahead

If you’ve already been receiving the income, there are a few steps you can take to mitigate the tax hit. Work with your accountant to see if there are tax deductions you can take to help offset income. High-income investors are more likely to itemize deductions on their income tax returns, meaning that they have write-offs exceeding the 2023 standard deduction.

One way to maximize deductions is by donating appreciated stock instead of cash. Donors can also front load their charitable donations by making several years’ worth of gifts to a donor-advised fund in one year. Another way to get ahead of any tax pain is to increase your tax withholding or make quarterly estimated tax payments.

Asset Location and Selection

One way to manage the taxes stemming from your income-paying assets going forward is to consider where these investments are held. Holding income-paying assets, particularly bonds and dividend-yielding stocks, in an individual retirement account allows you to defer the tax hit on the income until you begin to draw down from the account.

For cash you’re growing to serve short-term needs, it’s advisable to keep that in a taxable account for easy access. Some money market funds invest in municipal bonds and thus produce tax-exempt income, which may be beneficial for investors in high-tax locales.

Be aware that a taxable fund might generate more income compared to tax-exempt offerings. The right choice for you will depend on your individual circumstances.

“Never forget that it’s not about the tax you pay, but the income you keep,” said Steffen.