High Interest Rates Boost Fixed-Income Investments but Beware Taxes!

Soaring interest rates have rekindled Americans’ penchant for fixed-income investments

Soaring interest rates have rekindled Americans’ penchant for fixed-income investments like bonds and money market funds, but experts warn that they should be prepared for the taxes.

Federal Reserve raises benchmark interest rate

To battle inflation, the Federal Reserve has raised its benchmark, short-term fed funds rate to target 5.25%-5.50%, from near zero at the start of 2022 and to the highest level in 22 years.

Higher rates benefit savers

Higher rates hurt spenders who must pay more to borrow but are a boon to savers who receive a higher return on their money, especially with the economy uncertain and the stock market volatile.

Record growth in money market fund assets

Money market fund assets grew to a record, topping $5.69 trillion in the first three months of this year, Fed data show.

Higher interest income may come with a tax hit

That higher, steady and nearly riskless income may come with a price though: Come the new year, you may find yourself with a larger tax bill, experts say.

What are fixed-income investments?

Fixed-income assets are those with a regular, fixed payout such as savings accounts, money market funds, certificates of deposits (CDs), or government and municipal bonds. They are generally low-risk income generators.

How are fixed-income investments taxed compared with stocks?

Money generated from fixed-income assets is counted as income and taxed at your income tax rate, whichever bracket you fall into. In 2023, the IRS lists seven federal income tax rates ranging from 10% to 37%. Qualified stock dividend and capital gains tax rates for assets held at least a year range from 0% to 20%, depending on taxable income and filing status.

State taxes on fixed-income payments

Fixed income payments may also be subject to state taxes, especially in high-income tax states like California or New York.

Ways to lessen the tax blow

Consider investing in U.S. government-backed securities like T-bills, notes, or bonds to escape state tax. Municipal bonds are generally free from federal taxes and may also be free from state tax in the issuing state. Another option is to invest in fixed-income assets through nontaxable retirement accounts.

Are fixed-income investments worth it?

Despite the tax hit, experts say fixed-income investments are still worth it as they offer a steady source of income. Even if you have to pay taxes, you’re still making money.

Things to know about fixed-income investments

• Treasuries are safest as they are 100% guaranteed by the government.
• Money market funds are neither guaranteed nor FDIC insured.
• Municipal bonds can be harder to sell compared to Treasuries.
• CDs require careful management as the rate may change upon rollover or early withdrawal.

Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at [email protected] and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday.

This article originally appeared on USA TODAY: High interest rates boost fixed-income investments but beware taxes!