Broker Check
Tax Smart Investing for High Yield Savings Balances

Tax Smart Investing for High Yield Savings Balances

April 12, 2024

Tax Smart Investing for High Yield Savings Balances

What good is making 5% growth on your cash if you must give a third of it to the government?

I have seen people getting all excited about the interest rates they earn on their online savings or money market accounts, or even CDs.  And indeed, the 5% yields investors can score in these accounts are sweet for an investment that is very low risk (money market accounts) or no risk at all (FDIC insured accounts). 

But what matters isn’t what you make, but what you actually get to keep.  Remember interest (unlike, say stock dividends) is treated by the IRS as ordinary income.  If you make, say, $150,000 per year and are in the 22% tax bracket, and in New Jersey’s 6.5% bracket, then once you pay your taxes you actually only earned 3.575% after tax on that 5% CD. 

You might shrug and say “well, can’t do much about it – nothing is certain but death and taxes, right?” – but maybe, perhaps, you can…

Now, there is nothing wrong with keeping your emergency funds or funds you need for upcoming expenses in such accounts.  But if you have more than you need for cash reserves, you should know that there may be ways to earn high interest and keep most or all of what you make as well.  The best approach for each individual will vary based on age, tax bracket, and time horizon. (that’s the financial planner’s job to figure out).    Here I will look at a few approaches I have been using to avoid the tax hit on savings. 

Buy an annuity.  I know, everyone loves to hate on annuities.  But it is hard to hate on some of today’s fixed interest annuities.  One product I’ve used quite a bit over the last few years is currently offering an interest rate of 5.85% guaranteed for 5 years.   That is far above the rate being paid on 5-year CDs.  But the best part is that interest earned in an annuity is entirely tax deferred.   You don’t pay tax on the interest until you take the money out.  And even better than an IRA – there are no RMDs – so if you don’t need the money, you can let the income pile up tax deferred. 

Annuities have a reputation for being expensive and overly complicated.  And some are.   You also don’t want to invest money that you will need soon (since there are normally fees for exiting early).   But in recent years there has been an explosion in the number of companies offering low cost, simple, commission-free annuities with minimal fees and surrender charges.   If you want to see how such a product makes sense as part of your investment strategy, let me know. 

Move Interest Paying Investments to your Retirement Accounts.  This advice isn’t for everyone – but it might be smart for you particularly if you are older or nearing retirement.  The idea is, rather than piling up money in an online savings account and paying tax on all the interest, you can invest that “after tax” money in stock index funds.  Stock funds are not tax free.  They distribute dividends annually and may also distribute some capital gains based on their trading activity – but taxable income is usually modest and is generally taxed at the preferred capital gains rate of 0% / 15% / 20% depending on your income.  If the stock fund appreciates and you sell it, you will owe tax on the gain – but again, that gain is at a tax favored rate – and if you buy and hold until you die, you never have to pay tax on it! 

Sure, you may say, but stocks are risky, and your online savings account is safe.  True, so to maintain the same level of risk you had before, you will go into your IRA or 401k, sell stock funds equal to the amount of cash you just invested in your after-tax account, and buy cash like investments.  In your 401k that might be a “stable value” fund, or a short-term bond fund.  In your IRA, you can find high yielding money market funds, short term bond funds, or CDs which will provide you with the same high yields you were earning before – but you will get to keep it all!  (at least until you take the money out!). 

But don’t you want your retirement assets to grow faster?  If you are young, yes, you may want to leave the IRA/401 more invested in stocks.  But if you are older and facing the inevitability of taking retirement income from these accounts, you may be better off shifting their growth investments to their after-tax accounts. 

Buy Tax Free Bonds.   I don’t necessarily like this oft recommended strategy, but I will include it here just because it is so often talked about.  State and local municipal bonds pay interest that is not taxed by the federal government.  If you buy bonds issued by governments inside your own state, the interest may be free of state tax as well.  So, what’s not to like?  Well, because the market is smart.  Municipal bond prices are bid up so that the interest rates are much lower than those paid by a plain old US government Treasury bond.  To use the example above – after paying taxes on your 5% interest, you may only keep 3.55%.  But you will probably find that municipal bonds of equivalent quality are paying even less than that!   The good news is – you won’t pay taxes.  The bad news is – you’ll make less money. 

The municipal bond math often does work for people in very high tax brackets.  If you are in the 28% bracket, Muni-bonds are probably about a breakeven for you after tax.  If your marginal rate is 32% or more, then this might make sense.  But I would still rather use either of the two above strategies that let me earn the higher interest rate without paying tax on it.