Savers who’ve banked on high interest rates for the past couple of years may be in for a shock, some financial advisers say.
Not only will returns on their cash likely drop in the wake of the Federal Reserve’s recent rate cut, but thanks to the upcoming expiration of the Trump tax cuts at the end of next year, they could be taxed more on the interest they do earn.
“Income tax going up means less money in your paycheck,” said Brian Large, partner at Lenox Advisors. “Less interest on your cash means you’re losing return, plus, (that lower) interest will be taxable at a higher rate. This will affect savers across the board.”
What are the Trump tax cuts?
The Tax Cuts and Jobs Act of 2017 (TCJA), also dubbed the Trump tax cuts, was the largest overhaul of the tax code in 30 years. It included widespread tax reductions for businesses and individuals. Many of the benefits for individuals expire at the end of 2025.
One of the most significant changes for most Americans included lower income tax rates. The top rate fell from 39.6% to 37%, the 33% bracket dropped to 32%, the 28% bracket dipped to 24%, the 25% bracket slid to 22%, and the 15% bracket fell to 12%. The lowest bracket remained at 10%, and the 35% tax bracket was unchanged.
If the income tax cuts aren’t extended, the affected brackets will revert to pre-TCJA levels.
“At end of day, almost everyone’s tax rate will go up,” said Mark Steber, chief tax officer at tax preparer Jackson Hewitt.
Why are savings rates falling?
With inflation trending lower, the Fed has turned its attention to making sure the labor market remains robust.
Job growth has cooled this year as 23-year high interest rates slowed the economy and the pace of price hikes. To recharge the labor market, the Fed slashed its benchmark short-term fed funds rate in September for the first time in more than four years by a half a percentage point.
Banks quickly followed suit, lowering the interest rates they pay customers who hold cash in savings, money market accounts and certificates of deposit (CDs).
With economists forecasting more rate cuts in the coming months, savers who’ve been collecting up to 5% interest on their cash, without risk, will likely need to look elsewhere to get similar returns, Large said.
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How can Americans counter higher taxes and lower interest?
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First, Americans should consider taking advantage of current income tax rates before they potentially rise in 2026 by accelerating income in 2024 and 2025 if they can, advisers said.
For example, retirees may want to withdraw slightly more than their required minimum distribution in these years, said Nayan Lapsiwala, wealth management director at Aspiriant.
Others may consider a Roth conversion to save money by paying the lower tax rates now and no tax when they withdraw later from Roth accounts, he said.
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With yields dropping on fixed-income holdings like savings accounts, CDs, money market accounts, and bonds, consider moving some cash to stocks, Large said.
Not only will stocks usually generate higher returns than fixed-income holdings, those earnings will be taxed at a lower rate, advisers said.
That’s because fixed-income interest is taxed as income, but stock gains are taxed as capital gains. Income tax rates are already higher than capital gains rates and will likely move even higher after 2025 when Trump’s tax cuts expire.
For assets held at least a year, capital gains tax rates currently range between 0% and 20%, compared with income tax rates between 10% and 37%.
True, stocks may carry more risk, but risks can be mitigated using, for example, mutual funds or exchange traded funds (ETFS) comprised of a range of companies or sectors, advisers said.
In the current environment of falling interest rates, companies’ borrowing costs follow. That tends to favor small and midsized firms, which have room to grow and potentially have more financial upside for investors than their larger peers. When companies can afford to borrow more to invest in their businesses, that can drive greater profits and bigger returns on their stock, Large said.
Plus, money market funds are holding a record $6.42 trillion, according to the latest data from the Investment Company Institute. As rates continue to fall, advisers said they expect investors will look for better returns for that money, and stocks will benefit.
The best way to invest in smaller companies at a lower risk is to buy an index like the Russell 2000, which includes companies across a range of industries, Large said.
This approach, though, may not work for everyone, especially seniors who may need some regular income. In that case, Daniel Milan, managing partner at Cornerstone Financial Services, said buy high-quality, dividend-growth stocks. Dividends provide regular income while the stock appreciates.
“Dividend growth is the key,” he said. “Dividend growth, annually, has to be at or above inflation” to make the dividend worthwhile. Dividends are taxed as income unless the stock’s been held for at least a specified minimum period, which can vary but is usually a few months. In that case, the dividend is taxed at the lower capital gains rate.
Milan said he looks for annual 7% to 10% of dividend growth from a stock that yields 3.5% to 4% a year on average.
Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at mjlee@usatoday.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.
This article originally appeared on USA TODAY: Higher tax rates, lower interest rates are coming: How to handle it
