With Fed rate increases over the last 18 months, we now have a whole slew of fixed income investments that offer very attractive yields. Interest rates were so low for so long that many investors forgot that the interest from fixed income investments is generally taxable! With more and more people buying and holding bond positions, we’ll discuss the tax implications of holding these types of investments in this month’s blog. Read on to find out more.
Certificates of Deposit:
Certificates of Deposit (CDs) have gained renewed attention due to their current, attractive yield. In a recent blog post, we discussed the ins and outs of CDs in today’s rate environment. Now let’s take a look at their taxation. CDs are subject to ordinary income tax at both the federal and state levels in the year when interest is earned. To illustrate, suppose you acquired a one-year CD in September 2023 with monthly interest payments. Your 2023 tax liability would include the interest earned for the remaining months of the year. Similarly, the interest accrued each month until the CD matures in September 2024 would be included in your 2024 tax liability. Here’s an example of what the tax liability of a CD might look
- 1-Year CD Investment Details:
- Investment Amount: $5,000
- CD Yield: 5.35%
- Federal Tax Bracket: 24%
The interest earned from the CD is subject to federal income tax since it’s considered ordinary income. The formula to calculate the tax liability is:
- Tax Liability = Interest Earned × Tax Bracket
- First, let’s calculate the interest earned on the CD investment:
- Interest Earned = Investment Amount × CD Yield
- Interest Earned = $5,000 × 0.0535
- Interest Earned = $267.50
Now, let’s calculate the tax liability:
- Tax Liability = Interest Earned × Federal Tax Bracket
- Tax Liability = $267.50 × 0.24
- Tax Liability = $64.20
So, in this example, if you invest $5,000 in a 1-year CD with a yield of 5.35% and you’re in the 24% tax bracket, your tax liability on the interest earned would be $64.20.
Money-market funds are also experiencing an upsurge in yield (though some banks are offering much higher yields than others so please shop around!). Money-market funds also fall under the umbrella of ordinary income taxation. Like CDs, they are subject to federal and state taxes.
For the majority of investors, interest earned from Treasury securities is also considered ordinary income but enjoys exemption from state taxation. This unique feature can make Treasuries an attractive option for investors seeking to minimize their state tax liabilities.
All the rage in 2022 when they were paying interest of almost 10%, I-bonds are not subject to state income tax, however they are taxable at the federal level at the time the bonds are redemeed.
Municipal bonds, often favored by high-income individuals, offer a haven from excessive taxation. These bonds are exempt from federal taxation and, at the state level, are free from tax if issued by the investor’s resident state. For instance, a Pennsylvania resident holding a Pennsylvania-issued municipal bond would not owe state taxes on the interest earned. However, if the same investor holds a New Jersey-issued municipal bond, Pennsylvania state taxes would be applicable. Although municipal bonds typically offer lower yields compared to corporate or Treasury bonds of similar risk, their tax advantages can render them more appealing for certain investors. Here’s an example:
Imagine you are a resident of California and you’re considering investing in municipal bonds issued by the state. You have two options: a California municipal bond and a comparable taxable bond issued by a corporation. The California municipal bond has a yield of 3%, while the taxable corporate bond has a yield of 4%.
Tax-Free Yield Calculation:
For the California municipal bond, the yield of 3% is tax-free at both the federal and state levels. This means that if you’re in the 24% federal tax bracket and the 9.3% California state tax bracket, your tax-adjusted yield would be:
- Tax-Adjusted Yield = Municipal Bond Yield / (1 – Federal Tax Rate – State Tax Rate)
- Tax-Adjusted Yield = 3% / (1 – 0.24 – 0.093)
- Tax-Adjusted Yield ≈ 4.39%
Comparing the tax-adjusted yield of the California municipal bond (4.39%) to the yield of the taxable corporate bond (4.00%), you can see that even though the taxable bond had a higher initial yield, the tax advantages of the municipal bond make it the more attractive option in this scenario. Municipal bonds not only provide tax-free income but can often yield a higher after-tax return compared to taxable alternatives, especially for investors in higher tax brackets.
As the fixed income landscape changes and higher yields draw more investors, understanding the tax implications of these investments is important. By gaining a grasp of the taxation of these investments, investors can make more informed decisions aligned with their financial goals and tax planning strategies. Please reach out to an advisor at Innova Wealth Partners to find out more about the impact of these types of investments and their tax implications on your plan!
INNOVA is a SEC registered investment adviser. Information presented is for educational purposes only intended for a broad audience. INNOVA is not giving tax, legal or accounting advice, consult a professional tax or legal representative if needed. The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Any opinions, projections, or forward-looking statements expressed herein are solely those of author, may differ from the views or opinions expressed by other areas of the firm, and are only for general informational purposes as of the date indicated. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.