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Investors are enjoying higher yields from even the most mundane investments, but this year’s income could turn into a tax bite next spring. 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. The Crane 100 Money Fund Index has an annualized 7-day current yield of 5.16% as of Thursday. Even idle cash in some online savings accounts is growing to the tune of at least 4% APY these days. US3M US1Y 1Y line U.S. 3-month and 1-year Treasurys Higher yields, however, 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. For starters, work with your accountant to see if there are tax deductions you can take to help offset income, said Jerrod Pearce, a certified financial planner and partner at Creative Planning. 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 of $13,850 for singles or $27,700 if married and filing jointly. One of those deductions includes charitable giving, which you can maximize 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, Pearce said. These funds allow you to make a charitable contribution, collect a tax deduction for that year and then make grants to charities at any time. Another way to get ahead of any tax pain in the spring is to increase your tax withholding – that is, the amount of federal income tax that’s set aside from your wages – to pay a little more money toward your tax liability before April. You can also make quarterly estimated tax payments to help spread the liability and reduce or eliminate penalties. The upcoming due dates for the 2023 tax year are Sept. 15 and Jan. 16, 2024. “The No. 1 thing is that we want to make sure that people are paying in enough to not get hit with penalties,” said Pearce. “For those who want to do quarterly estimated tax payments, it’s a good budgeting tool.” Asset location and selection One way to manage the taxes stemming from your income-paying assets going forward is to look at where these investments are held. If you’re holding income-paying assets – particularly bonds and dividend-yielding stocks – for the long term, it may make better sense to hold them in an individual retirement account . This way, you’re deferring 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, you’ll want to keep that in a taxable account for easy access. To that effect, some money market funds invest in municipal bonds and thus produce tax-exempt income. Investors in high-tax locales may be especially interested in state-specific tax-exempt money market funds. For instance, there’s the Vanguard California Municipal Money Market Fund (VCTXX) , which has an expense ratio of 0.16% and a 7-day SEC yield of 2.67%. The Fidelity New York Municipal Money Market Fund (FAWXX) carries an expense ratio of 0.42%, and it has a 7-day yield of 3.34%. Be aware that a taxable fund might generate more income compared to tax-exempt offerings. Which one is 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.
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