In a rapidly changing financial landscape, Americans are flocking to fixed-income investments, attracted by the promise of higher returns. However, the excitement of increased earnings is often overshadowed by unexpected tax bills. Investors have poured a large chunk of their savings into money-market funds, U.S. government bonds, and even I bonds have all gained significant popularity.
The primary driving force behind this renewed enthusiasm for fixed income is the prospect of higher returns. For over a decade, these assets barely provided investors with any significant gains. Today, many fixed-income investments are yielding 4% or more annually.
However, this higher return comes with an important caveat – taxes. The same investments that once generated meager tax bills may now lead to substantial tax liabilities. In most cases, no taxes are withheld at the source, leaving many taxpayers facing an unexpected tax bill when they file their income tax returns.
The tax implications vary depending on the type of fixed-income investment you choose, whether it’s a high-yield money-market account, a certificate of deposit, or an I Bond. Factors such as federal and state income taxes, the timing of tax payments, and your tax bracket all play a crucial role in determining your tax liability.
It’s important to note that these tax considerations primarily affect investments held in taxable accounts, not tax-deferred retirement plans like IRAs and 401(k)s. Earning more income from your investments in taxable accounts can inadvertently push you into a higher tax bracket, leading to unforeseen consequences.
Below is a breakdown of the tax implications for various fixed-income investments.
Is interest earned on certificate of deposit taxable?
Certificates of Deposit (CDs): Interest earned on CDs is treated as ordinary income, subject to both federal and state income taxes in the year you earn it. For instance, on a three-year CD, you would owe taxes on the interest earned and paid out each year.
Is income generated from I Bonds subject to taxation?
I Bonds: These inflation-adjusted U.S. savings bonds remain attractive. Notably, there are no state or local taxes on the interest earned, making them particularly appealing for investors in high-tax states. Federal taxes on I bonds are deferred until you redeem them, and there is an option to pay federal income tax annually. Under certain circumstances, you may exclude some or all the interest from federal income taxes if used for higher education expenses.
Do I incur taxes on Money Market Funds?
Money-Market Funds: The tax treatment of money-market funds varies depending on whether they are taxable or tax-free. Taxable money-market funds are subject to federal and state income taxes, whereas tax-free money-market funds depend on the underlying investments within the fund.
Is interest income from Treasury bills subject to taxation?
Treasury Bills: Generally, Treasury bills are exempt from state and local taxes. However, you’ll owe federal taxes on the interest payments each year when you file your federal tax return. If you purchase Treasuries through the TreasuryDirect website, you can opt for tax withholding.
Does the interest income earned from Municipal Bonds need to be reported on my tax return?
Municipal Bonds: Bonds issued by state, city, and local governments are typically free from federal income taxes and, in some cases, from state income taxes in the issuing state. The tax implications may vary depending on your state of residence and the origin of the bond.
Investors should be proactive in managing their tax liabilities. It is recommended to make estimated tax payments throughout the year or adjust your tax withholding to align with the higher yields.
While the allure of higher returns in fixed-income investments is undeniable, it’s essential for investors to be cognizant of the tax implications. By understanding the tax rules and planning accordingly, individuals can make the most of their fixed-income investments while effectively managing their tax liabilities.
Article by Muhammad Junaid, Senior Tax Manager