Many Americans are earning more on cash after interest rate hikes from the Federal Reserve — and that income can trigger a surprise at tax time.
“So many people were shocked by their cash interest earned” and taxes owed, said Boston-based certified financial planner Catherine Valega, founder of Green Bee Advisory. She is also an IRS enrolled agent.
Interest from savings accounts or certificates of deposits incurs regular or “ordinary income” taxes, depending on your federal income tax bracket. Some investors also owe state taxes on interest.
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Savers are still earning higher yields on cash despite uncertainty from the Federal Reserve on future interest rate cuts this year.
The top 1% average rate for savings accounts was hovering around 5% and top-earning 1-year certificates of deposit were paying about 5.5% as of May 16, according to DepositAccounts.
Meanwhile, some of the biggest money market funds were paying north of 5% as of that date, according to Crane Data.
The first question someone should ask is how much cash do they still need and whether it makes sense to invest some of that money elsewhere, according to CFP Ashton Lawrence, director at Mariner Wealth Advisors in Greenville, South Carolina.
Typically, financial experts recommend keeping an emergency fund of three to six months to apply to living expenses. But the amount could be higher depending on your needs or short-term goals, experts say.
For those ready to explore tax-friendly investments for cash allocations, here are some options to consider.
‘One of the best options’ for cash
If you’re a higher earner, you may consider municipal bonds, muni bond funds or muni money market funds, experts say.
There are no federal taxes on interest accrued on these assets and you could even avoid state and local levies, depending on where you live. But muni bond interest can trigger higher Medicare Part B premiums, experts warn.
A muni bond exchange-traded fund is “one of the best options available” for tax-advantaged cash, said CFP Andrew Herzog, an associate wealth advisor at The Watchman Group in Plano, Texas.
Muni bond fund yields can be lower than their taxable counterparts. But you need to calculate the after-tax yield on fully taxable funds for an apples-to-apples comparison.
Save in ‘high-income tax states’
Another option for cash is Treasury bills, or T-bills, with terms ranging from one month to one year, according to Thomas Scanlon, a CFP at Raymond James in Manchester, Connecticut.
While you’ll still owe federal taxes on T-bill income, the assets are exempt from state and local taxes.
“This really matters in high-income tax states like California, New York and others,” Scanlon said. But there’s no benefit in places like Florida or Texas with no state income tax.