Why Higher Interest Rates May Mean Higher Taxes for Investors

Higher interest rates can provide welcome relief to savers, but they can also lead to higher tax bills for investors. Let’s examine how asset location, or choosing which investments to hold in which accounts, can help reduce the tax bite.

Tax Treatment of Nonretirement Accounts

Q: What’s the tax treatment of income earned in a nonretirement account like a taxable brokerage account or a taxable bank savings account?

A: If you own an investment, whether some sort of a cash investment or a bond investment, anything that’s generating ordinary income in the form of interest is going to be taxed at your ordinary income tax rate.

If you own something that is paying out capital gains or dividends, that’s eligible for a lower tax rate, which is 15% or 20% for most taxpayers.

For people with fairly low levels of overall income, they’ll pay a 0% tax rate on capital gains and dividends. But that ordinary income that you’re getting from bonds, that you’re getting from now decently yielding cash accounts and CDs and so forth, that will be taxed at your ordinary income tax rate.

IRAs and Company-Sponsored Retirement Plans

Q: Do those annual taxes matter if the money that’s generating income is held in an IRA or a company-sponsored retirement plan?

A: It doesn’t matter. If you own some sort of high-income-producing security within the context of that retirement plan, you are not subject to tax payments on that account on a year-to-year basis. You’re typically only going to be subject to taxes either when you’re putting the money in, in the case of Roth contributions, or when you’re pulling the money out, in the case of traditional tax-deferred contributions. So, don’t worry about this if most of your funds are inside of a retirement account.

Another wrinkle, though, is if you own the investment inside of a taxable account; even if you’re reinvesting those distributions, the tax rate is still the same. It doesn’t help you, unfortunately, if you’re reinvesting those distributions. That’s an important thing to keep in mind.

Should You Keep Securities in Tax-Sheltered Accounts?

Q: If you own securities that generate a decent amount of income, is it wise to keep them in some sort of tax-sheltered account?

A: Yes, and this is why financial and tax advisors often talk about the concept of asset location, not to be confused with asset allocation, which is how we apportion our investments across different investments. This is how we apportion our investments across different account types. And for most of us, we have three main silos that we could use.

One would be Roth, where we’re making the contributions with aftertax dollars; we’re pulling the money out tax-free in retirement.

Another would be traditional tax-deferred accounts where we are typically earning a tax break on our contribution, paying full freight on the way out. If you own high-income-producing securities, those are the accounts to favor because you won’t get dinged on a year-to-year basis.

If you hold money in a taxable brokerage account, that’s where you need to be really careful about what you’re putting in there. When we think about broad market index funds, for example, or better yet, exchange-traded funds—they’re a perfect choice for a taxable brokerage account because they’re going to not generate much of that year-to-year cash flow on which you’ll owe taxes.

On the other hand, you’d want to really think twice about holding high-income-producing investments inside of that taxable brokerage account because you are paying that ordinary income tax year in and year out as long as you’ve got the investment inside there.

How To Help With Tax Drag for Cashlike Investments

Q: For investors who are trying to keep cashlike instruments or shorter-term instruments for their spending needs and aren’t holding them in these tax-sheltered accounts, is there anything they can do to help limit that tax drag?

A: Many of us, especially if we’re in our preretirement years, probably have some near-term or intermediate-term goals for our money and we want to keep the funds liquid and accessible, so a retirement account doesn’t usually make sense. One idea to consider would be to hold, if you’re owning a cash instrument, some sort of a municipal money market fund, municipal-bond fund, or you can own individual securities that are issued by municipalities. The beauty of that is that you will not owe federal income tax on those income distributions. And if you happen to buy a security that’s issued by your home state, or even better yet your home municipality, you will avoid those state and local taxes as well. That’s something to consider, especially for people who are in higher-income tax brackets. If you can avoid that income tax hit on a year-to-year basis, that can be very, very valuable.

How To Compare Taxable and Tax-Exempt Yields

Q: How can you determine whether you are better off using something like a municipal money market or a municipal-bond fund versus one that’s taxable?

A: I would recommend using what’s called a tax-equivalent bond calculator. Fidelity has a good one, as do many other financial institutions. You hop on there, and assuming you’re comparing like investments—so a municipal-bond fund with similar duration and credit-quality characteristics to the taxable-bond fund—you can compare them in terms of what your yield would look like once those tax effects are factored in. My husband and I typically hold municipal funds for bond exposure in our taxable account. But investors should run the numbers first. Investors who are at lower ordinary income tax rates may be better off sticking with the taxable bond or the taxable cash instrument.