There’s no ‘free lunch’ with high-interest cash options, advisor says. How to plan for taxes

Savers are now getting higher cash yields after several interest rate hikes from the Federal Reserve. But taxes on those earnings could be a surprise, experts say.

As of Aug. 24, the top 1% of savings accounts were paying average rates north of 4.5%, and the most competitive one-year certificates of deposit offered more than 5.5%, according to DepositAccounts.

Meanwhile, Treasury bills, which have terms ranging from one month to one year, had yields well above 5% as of Aug. 24, and the biggest money market funds were also paying more than 5%, Crane Data reported.

“Everyone thinks it’s kind of a free lunch,” said Tommy Lucas, a certified financial planner and enrolled agent at Moisand Fitzgerald Tamayo in Orlando, Florida. “But you’ve got to consider the tax man.”

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Interest from high-yield savings accounts and CDs creates “ordinary income” every year, subject to federal and state income taxes. Falling into the regular tax brackets, ordinary income is less favorable than long-term capital gains.

Similarly, taxable money market funds — which typically invest in shorter-term lower-credit-risk debt — and Treasury bills also trigger ordinary income. But Treasury bill earnings aren’t subject to state or local taxes.

For example, let’s say you’re earning 4% annual interest on $100,000 in a CD. If you’re in the 22% federal income tax bracket, you may have an extra $880 in federal tax liability.

Plus, “it may affect other tax planning opportunities,” said Lucas, such as Roth individual retirement account conversions or the chance to harvest investment gains at the 0% capital gains rate.

However, some higher earners are opting for municipal money market accounts, which invest in state-issued debt and offer federal tax-exempt interest. Of course, investors need to compare after-tax yields for regular money market funds to see which option is best.

When buying assets that create income, it’s important to consider your complete financial picture, said CFP John Loyd, an enrolled agent and owner at The Wealth Planner in Fort Worth, Texas. 

“Pretty much every financial decision is going to have a tax impact, whether it’s immediate or down the road,” he said.

If you’re buying income-producing assets outside of a retirement account or in a brokerage account, you can expect yearly income. But you won’t have the same problem for products held within tax-free or tax-deferred accounts, Loyd said.

“I’ve been doing a lot of CDs for clients, and we’ve been doing the vast majority of those inside retirement accounts if we can,” he said.