KEY TAKEAWAYS
- Interest rates are expected to be held at higher-than-usual levels this year, making high-yield savings accounts more fruitful—and potentially increasing the amount of taxes due next year.
- Opening a Certificate of Deposit in tax-advantaged accounts like an IRA or 401(k) can defer or even exempt taxes from interest earned.
- Some bonds and investments earn interest tax-free, such as municipal bonds or U.S. savings bonds used for higher education spending.
The Federal Reserve isn’t in a rush to cut rates, which means you could be on the hook for more taxes next year on the interest you earn now. However, a few smart moves can help you soften that blow.
Higher rates in recent years have allowed many banks to raise rates on savings accounts, money market accounts, and Certificate of Deposit (CD) accounts, which increases the amount savers earn in interest.
The IRS treats interest payments of $10 or more as income, meaning taxpayers will pay the same amount in taxes on the interest they earned.
Savers face that situation this year as they prepare to file their 2024 taxes. They may have limited options for offsetting that tax as the filing deadline looms, but here are some ways to start early and get ahead of next year’s tax bill.
Saving In Tax-Advantaged Accounts
Placing money into a CD or high-yield savings typically earns interest quicker, but it also builds up taxes quicker. However, some tax-advantaged accounts are exempt from taxation, or taxation is deferred to a later date.
Tax-deferred savings accounts, such as traditional individual retirement accounts (IRA), 401(k) plans, and Health Savings Accounts, allow you to earn interest on savings and provide immediate tax deductions on all contributions. However, taxpayers will still have to pay taxes once they withdraw their savings from these accounts.
Savers can also open a CD in a traditional IRA—any contributions to the CD are tax-deductible and allow savers to defer taxes until they withdraw. Putting a CD in a traditional retirement account typically has a longer maturity date and higher interest rates.
Additionally, savers can offset what they will pay in taxes on an independent CD by contributing the same amount they earn in interest to a tax-deductible savings account such as a Roth IRA or donating it, said Jake Falcon, wealth advisor and CEO of Falcon Wealth Advisors.
“Making interest and having tax liabilities is a good thing. I don’t want people to get caught up in paying the least amount of taxes by not investing their money or not earning it,” said Falcon. “It’s always important to understand that gains are good and taxes are good.”
Utilize Tax-Advantaged Investments
Alternatively, you could look at investing money into bonds that are exempt from federal income taxes.
A municipal bond is essentially a loan given to local, county, and state governments to pay for capital expenditures, such as the construction of highways, bridges, or schools. In return, the government promises to repay the loan, including interest earned during the time.
Typically, municipal bonds are tax-free at the federal level but can be taxed at the state or local level. Municipal bond funds and municipal money market funds work similarly tax-wise but vary in the type of investment.
“[You can] place money you don’t need right away into treasuries or municipal bonds issued by your state,” said certified financial planner Cathleen Tobin in an email to Investopedia. “A municipal bond fund might also be attractive for people in higher tax brackets, such as 32% or above.”
Treasury bonds and U.S. savings bonds are debts issued to fund federal spending. Interest earned through these bonds is subject to federal income tax but not state or local taxation.
However, if the interest earned on a T-bond or a Series EE or I savings bond is used for higher education spending, it is exempt from federal taxes.