Navigating Tax Rules for Profitable Bond and CD Investments

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As Americans revel in the higher returns on their Treasury bills and other fixed-income investments, they might need to brace for a blow when tax season rolls around. Over the past five weeks, investors have funneled a net $91.1 billion into money-market funds, with U.S. government bonds, high-yield bonds, bond funds, and other fixed-income assets also enjoying a surge in popularity. The Treasury Department’s website even crashed last year due to the overwhelming demand for I bonds.

The lure of returns is driving Americans back to fixed income. After a decade of negligible yields, these assets are now returning 4% or more annually. However, this windfall comes with a catch: the tax bill. The very same investment that resulted in a minuscule tax bill just two years ago could now lead to a significant tax liability. In most cases, no tax is withheld, setting many taxpayers up for an unexpected tax bill come next spring.

Americans Enjoying High Return Fixed-Income Investments – But What About The Tax?

Higher Returns, Higher Taxes

Over the past five weeks, American investors have injected a net sum of $91.1 billion into money-market funds, according to data from Refinitiv Lipper. Other fixed-income assets, such as U.S. government bonds, high-yield bonds, bond funds, and I bonds have also gained popularity. The appeal of these investments lies in their returns. After a decade of minimal returns, many of these assets are now yielding 4% or more annually.

However, these returns come with a catch – higher tax bills. Most of these investments do not withhold tax, which could lead to an unexpected tax bill when investors file their taxes. "Rates have been so low for so long, people aren’t used to actually receiving interest income and they don’t realize it’s taxable," said Neil Denman, a certified public accountant based in Little Rock, Ark.

The Impact of Interest Income on Taxes

Depending on an investor’s tax bracket and the amount of interest income earned, the additional tax could be substantial. For example, an investor in the 30% tax bracket with $2,000 of interest income would have an additional $600 in tax. This could be a significant consideration for investors, especially those with large investments yielding high interest.

Investment income earned from different types of fixed-income investments is taxed differently. The tax implications could also vary depending on whether the investor owes federal or state income taxes or both. The tax year in which the investor owes tax could also be different.

Tax Considerations for Different Fixed-Income Investments

I Bonds, for example, are not subject to state or local taxes on the interest earned. Federal taxes on these bonds are typically due when the bond is cashed in, although there is an option to pay the income tax annually. In some cases, the interest might be exempted from federal income taxes if the proceeds are used to pay for higher education.

On the other hand, interest earned on Certificates of Deposit (CDs) and Money-market funds is taxed as ordinary income at both the federal and state level. Treasury bills are generally exempt from state and local taxes, but federal taxes are due when interest payments are received each year.

The tax considerations could have significant implications for investors, especially those in taxable accounts rather than tax-deferred retirement plans like IRAs and 401(k)s. Increased investment income could push investors into a higher tax bracket, leading to unintended consequences, notes Dan Griffith, director of wealth strategy at Huntington Private Bank in Canton, Ohio.

The Takeaway

While the allure of higher returns on fixed-income investments is undeniable, investors must also consider the tax implications. Depending on the investment type, tax bracket, and state of residency, the higher returns could lead to a hefty tax bill. To prevent surprises in the next tax season, Edward Ryan, an enrolled agent in Rutherford, N.J., advises investors to estimate their taxes throughout the year based on their higher yields.

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