Savers who have been counting on high interest rates in recent years could be in for a shock, some financial advisers say.
Not only is the return on their cash likely to decline 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 also be taxed more heavily on the interest they earn.
“Higher income taxes mean less money in your paycheck,” says Brian Large, partner at Lenox Advisors. “Less interest on your cash means you lose returns, and (that lower) interest will be taxable at a higher rate. This will impact savers across the board.”
What are Trump’s tax cuts?
The Tax Cuts and Jobs Act of 2017 (TCJA), also known as the Trump tax cuts, was the largest overhaul of the tax code in three decades. It included widespread tax cuts for businesses and individuals. Many of the benefits for private individuals will expire at the end of 2025.
One of the most important changes for most Americans was lower income tax rates. The top rate fell from 39.6% to 37%, the 33% bracket fell to 32%, the 28% bracket fell to 24%, the 25% bracket fell to 22% and the 15% bracket fell to 12 %. The lowest bracket remained at 10% and the 35% tax bracket remained unchanged.
If the income tax cuts are not extended, affected tax brackets will return to pre-TCJA levels.
“Ultimately, the tax rate will go up for almost everyone,” said Mark Steber, chief tax officer at tax attorney Jackson Hewitt.
Why are savings interest rates falling?
With inflation on the decline, the Fed has turned its attention to ensuring 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 increases. To revive the labor market, the Fed cut short-term interest rates by half a percentage point in September for the first time in more than four years.
Banks quickly followed suit and lowered the interest rates they pay to customers who hold cash in savings, money market accounts, and certificates of deposit (CDs).
With economists predicting more rate cuts in the coming months, savers who have been collecting up to 5% interest on their cash without risk will likely have to look elsewhere to earn similar returns, Large said.
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How can Americans combat higher taxes and lower interest rates?
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First, Americans should consider taking advantage of current income tax rates before they potentially rise in 2026, accelerating revenues in 2024 and 2025 if they can, advisers said.
For example, retirees may want to take out a little more than their required minimum benefit during these years, says Nayan Lapsiwala, director of asset management at Aspiriant.
Others may consider a Roth conversion to save money by paying the lower tax rates now and no taxes when they withdraw money from the Roth accounts later, he said.
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With yields on fixed-income investments such as savings accounts, CDs, money market accounts and bonds falling, consider moving some cash into stocks, Large said.
Not only will stocks typically yield higher returns than fixed-income investments, but this income will also be taxed at a lower rate, advisers say.
That’s because fixed income is taxed as income, but stock gains are taxed as capital gains. Income tax rates are already higher than capital gains rates and are likely to become even higher after 2025, when the Trump tax cuts expire.
For assets held for at least a year, capital gains tax rates are currently between 0% and 20%, compared to income tax rates between 10% and 37%.
It’s true that stocks may carry more risk, but the risks can be mitigated by using, for example, mutual funds or Exchange Traded Funds (ETFS) that consist of a range of companies or sectors, advisers say.
In the current environment of falling interest rates, corporate borrowing costs are following suit. This tends to benefit small and medium-sized companies, which have room to grow and potentially greater financial benefits for investors than their larger peers. When companies can afford to borrow more to invest in their businesses, it can yield bigger profits and greater returns on their shares, Large said.
Additionally, money market funds hold a record $6.42 trillion, according to the latest data from the Investment Company Institute. As interest rates continue to fall, advisors expect investors will look for better returns for that money, and stocks will benefit.
The best way to invest in smaller companies with lower risk is to buy an index like the Russell 2000, which includes companies from a range of industries, Large says.
However, this approach may not work for everyone, especially seniors who may need a steady income. In that case, Daniel Milan, managing partner at Cornerstone Financial Services, said buy high-quality stocks with dividend growth. Dividends provide regular income while stocks increase in value.
“Dividend growth is the key,” he said. “Dividend growth must be at or above inflation annually” to make the dividend worthwhile. Dividends are taxed as income unless the shares are held for at least a certain minimum period. This can vary but is usually several months. In that case, the dividend is taxed at the lower capital gain rate.
Milan said he expects 7% to 10% annual dividend growth from a stock that averages 3.5% to 4% annually.
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 mornings.
This article originally appeared on USA TODAY: Higher tax rates, lower interest rates are coming: How to deal with them
