How to use interest rates to reduce taxes

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How to use interest rates to reduce taxes

As interest rates have skyrocketed, the amount of cash that Americans are putting into high-yield savings accounts, certificates of deposit and money-market accounts has skyrocketed, resulting in 4% or maybe 5% or maybe even 7% or more. It's a great deal, and it will make you feel like a really smart investor on days when the stock market is tanking.

The government is going to want its cut - and soon.

If you have a large amount of cash and have earned so much income on it this year that it'll cause you to owe far more than you normally do in April when you file your federal tax return for 2023, Bishop warns.

The interest rate you pay will differ based on your income, which is something many people forgot about in the past when interest rates were so low. The tax rate for most people is likely to work out to be more in taxes than capital gains taxes, as those with enough cash to worry about their tax on it are likely to pay at least 22% in federal income taxes, and possibly up to the highest tax rate of 37%.

The interest income is taxed yearly, regardless of the transactions involved, and state taxes could also be added on top.

The same rules apply to short-term capital gains, but long-term capital gains on investments are taxed at a lower rate and could be zero for some. The high bracket for most is 15% and the highest bracket for the wealthy is 20 percent, plus possibly some additional investment taxes for the very wealthy.

If you have $250,000, which sounds crazy, but happens more than you think, and some people have to keep cash in several different banks to stay within the FDIC insurance limit. You may have made more than $12,000 in interest income at 5% by the end of the year, which probably makes you happy. If you're paying 22% of federal taxes, that could add an additional $2,600 to your tax bill. In the highest tax bracket, that could add an additional $4,600.

Are you crying because of spilled milk?

Nobody likes to pay taxes, but it's just a portion of your gain, not the whole thing.

Bishop says if people are really upset with paying taxes on interest income, there are still plenty of banks that will offer them a less good deal. Bankrate.com reported that the national savings rate average was just 0.56%, despite the high rates available from online banks.

However, if you want to become a tax-savvy investor, you should look at the tax you're paying and try to reduce it. Sullivan, a certified financial planner, is a Co-Founder and Director of Financial Planning at Prism Planning Partners in Libertyville, Ill.

One go-to for many is municipal bonds, which can sometimes be triple-tax-free - no federal, state or local taxes - depending on the investment. But there are some drawbacks. Bishop notes that municipal bonds aren't paying enough now to be a real alternative. The municipality's bond income can be included in the computation of modified adjusted gross income, which means it's not an escape from Medicare IRMAA surcharges.

Treasurys are another option and will usually be tax-free at federal and sometimes state levels, said Nicole Davis, CPA of Butler-Davis Tax & Accounting in Covington, Ga. Series I bonds are only taxable when cashed in, and some tax can be avoided if the funds are used for specific purposes, such as paying for college.

You can invest in Treasury ETFs or other cash-equivalent securities that typically don't have tax implications until you sell them. And you can always offset any of these investments and interest income gain with losses, and carry over $3,000 a year in losses against ordinary income on your tax return.

If you're not making enough interest income due to your tax bill, it's unlikely that you're going to harvest losses to cut those gains. There is still time to look at your investments and figure out a tax-efficient strategy before the end of the year.

How do you know if you should fire your financial advisor?