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Uncle Sam is about to take his share of those juicy yields you’ve been earning through 2023. This year, investors didn’t have to work terribly hard to get paid high yields from their income-paying investments. The Crane 100 Money Fund Index touts an annualized 7-day yield of 5.2%. For those willing to sacrifice some liquidity, a 1-year certificate of deposit is yielding 5.55% at LendingClub and Bread Financial . But a tough reality awaits savers who’ve piled into these cash investments: Interest income is taxed at the same rate as ordinary income, which can be as high as 37% at the top marginal rate. “For so long, we were in this environment where it was kind of a shrug: What difference does it make if I owe tax on 25 or 50 basis points in income?” said Christine Benz, director of personal finance and retirement planning at Morningstar. “But now that income levels are more meaningful, it becomes a more meaningful consideration.” To make things worse, investors who need to get a hold of that cash in short order are likely to keep assets like interest-bearing money market funds in their taxable accounts, where the interest they produce won’t be sheltered from the authorities. “When people do their taxes for the 2023 tax year, they may have some nasty surprises in terms of having held high income producers in taxable accounts,” Benz said. One caveat, however: Treasury bill or note income is exempt from federal income tax and only subject to state and local taxes, whether assets are held at Treasury Direct or at a brokerage. Last-minute tax triage If you’ve been collecting the added interest all year, there are a few steps you can take during your year-end tax planning to manage the hit. For instance, you can try to stuff more money into your 401(k) retirement plan at work, said Jeffrey Levine, CPA and chief planning officer at Buckingham Strategic Wealth in St. Louis. In 2023, the contribution limit is $22,500, and employees aged 50 and over can sock away another $7,500 in catch-up contributions. You can also add money to your health savings account if you have a high-deductible health insurance plan. If you have self-only coverage under one of these plans, you can stash up to $3,850 in 2023 ($7,750 if you have family coverage). Socking away more money in these accounts has the pleasant side effect of lowering your adjusted gross income – and in turn, this could help reduce the pain of the taxes you might face on your interest, Levine said. “It comes down to the straightforward stuff,” he added. Another tax-saving staple of year-end planning if you itemize deductions – that is, you can claim write-offs that are greater than the 2023 standard deduction of $13,850 for single filers ($27,700 for married, filing jointly) – you can make charitable donations of appreciated stock that you’ve held for more than a year. In this case, you donate the shares directly to your favorite charity. Going forward Learn from this year’s tax hit and be mindful of where you’re holding your income-producing assets. “It comes down to potentially looking at ‘Should I take some of this fixed income and put it in my retirement account if it wasn’t there before?'” said Levine. “Are there other places to look at holding these investments?” Corporate bonds spin out income that’s taxable on a federal, state and local levels – so you might want to keep those in tax-deferred accounts, like your 401(k) or an individual retirement account. Taxable bond funds would also fare better in those accounts. Meanwhile, stocks and exchange traded funds that pay out qualified dividends, which face a tax rate of up to 20%, might be better off in your brokerage account. The same goes for municipal bonds, which pay income that’s free of taxes at the federal level and state and local levies if investors live where they’re issued. Reevaluate your money market fund. Even if you need to keep that in your brokerage account, consider shifting to a municipal money market fund, which pays income that’s exempt from federal income taxes. The Vanguard Municipal Money Market Fund (VMSXX) has a 7-day SEC yield of 3.13% and an expense ratio of 0.15%. For residents in high-tax states, state-specific muni money market funds are another idea. The Vanguard New York Municipal Money Market Fund (VYFXX) and Fidelity California Municipal Money Market Fund (FSPXX ) are two possibilities, with 7-day SEC yields of 3.03% and 2.51%, respectively. VYFXX has an expense ratio of 0.16%, while FSPXX has an expense ratio of 0.3%.
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