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I have a million dollars and I want to put it to work for me. Where can I place it to get the most passive income from it? And how can I minimize taxes on that so I can keep more of that money?
– Andrea
While the current high interest rate environment has been challenging in many ways, the upside is that investors looking to earn passive income can do so more easily than at any time since the 2007-2009 global financial crisis.
Before laying out some options to take advantage of current returns and considering the associated tax implications, it’s helpful to evaluate your existing financial picture and ask yourself some key questions that will impact where you put the money . (A financial advisor can help you do both, and this tool can help you match one.)
Evaluate your financial situation
Investing your $1 million dollars with a view to generating passive income may very well be the best option for this money. However, rather than viewing your decision in a vacuum, I recommend looking at the money in the context of your broader financial situation and longer-term goals. In particular, it may be helpful to consider the following questions:
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Your total assets: Do you already have an investment portfolio? Where are these assets located and what are their tax implications (e.g. IRA, Roth IRA, 401(k), brokerage account)?
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Your employment status: How many more years do you have an income that you can add to your assets?
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Other income: Do you have any other sources of income (social security, pension, etc.)?
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Goal for generating passive income: Are you retired and do you want to finance your current expenses? Or is it to provide supplemental income while the rest of your portfolio continues to grow?
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Growth vs. income: Are you willing and/or able to sacrifice growth and purchasing power for the sake of income? If income is the only goal or need, expectations for growth and your ability to maintain asset purchasing power should remain low.
After thinking about these questions, you may find another purpose for the money. (And if you need more help assessing your financial situation, consider talking to a financial advisor.)
Options for generating passive income
Given the rise in interest rates since March 2022, income-oriented assets have become more attractive to people looking to get a reasonable return on their investments. Building a portfolio that includes a variety of assets that can generate a collective return is often a good approach, as opposed to investing in a single product or security. While a financial advisor can help you build a robust portfolio, here are some options to consider:
Money market funds
Although money market funds are widely considered an alternative to keeping cash in a savings account, they have become a hot topic among investors amid interest rate increases. Before the recent series of interest rate hikes by the Federal Reserve, money market yields were close to 0%, meaning you were essentially earning no interest on your investment. However, today yields are closer to 5%, making this a much more attractive option for generating income with low risk.
Municipal bonds
Municipal bonds are another solid option for income-oriented investors. As with any investment, you should consider your objectives before investing in municipal bonds as the risk profile and income potential vary among securities. Evaluating credit ratings and durations in relation to the returns you expect to earn in exchange for taking on credit and duration risk is a necessary step to take. Because they are generally not subject to federal taxes (or state taxes in the state where they are issued), municipal bonds tend to be a tax-efficient investment.
Certificates of Deposit
Like money market funds, certificates of deposit (CDs) have gained popularity as interest rates have risen. CDs can be particularly attractive if you don’t need to liquidate the investment within the target time horizon, as you typically pay a penalty for early withdrawals. It is therefore important to align the maturity date of a CD with the date on which you expect to need the money back.
Dividend stocks
If you need some growth to accompany the passive income your money generates, you may want to consider investing in dividend stocks. The S&P 500 High Dividend Index paid a dividend yield of more than 5% at the end of September, making it competitive with other publicly traded options. Unlike fixed income products, dividend stocks tend to offer more opportunity for appreciation, which can help you maintain your purchasing power over time if that’s an issue.
Other options
Of course, there are even more options to generate passive income. These include government bonds, high yield bonds, master limited partnerships (MLPs), real estate investment trusts (REITs) and many others. Before committing to each of these risks, consider what risk you are willing and able to take, how much income you need, and whether some element of growth is necessary. Also evaluate the tax implications of the investments you choose. (And if you need more help evaluating and selecting investments, consider consulting a financial advisor.)
Soften the impact of taxes
Each of the options mentioned above is treated differently for tax purposes. The interest earned by fixed income securities is taxed at normal income tax rates. Taxes on stock dividends depend on how long you own the asset. Qualified dividends are taxed at long-term capital gains rates, while ordinary dividends are taxed at ordinary income rates. Appreciation from shares is taxed at the capital gains rate.
It is important to understand the tax treatment of individual assets as this will play a role in determining the type of account in which these assets are held. In general, owning individual stocks and bonds, as well as their passively managed index alternatives, is more tax efficient than actively managed mutual funds. Therefore, it is generally advisable to own individual stocks, bonds, and index funds in taxable investment accounts. Tax-advantaged accounts such as IRAs and 401(k)s, and after-tax Roth IRAs, are generally better suited for your actively managed funds and less tax-efficient securities such as high-yield bonds.
By thinking holistically about the assets you own and what you can spend them on, you can ultimately reduce taxes. Naturally, it may be helpful to speak with your tax advisor to better understand the impact on your individual situation, given your specific tax brackets. (Consider a match with a financial advisor with tax expertise.)
In short
Positioning your assets for passive income generation is a good strategy, but only if it aligns with your long-term financial needs and goals. Before choosing this approach, critically assess your personal situation and the reason behind seeking passive income. From there, you can consider various fixed income products such as bonds and CDs, as well as equities such as dividend-paying stocks. Each option has its own tax implications, and the type of account in which the securities are held will also have an impact on taxes.
Tips for Generating Passive Income
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A CD ladder is a way to take advantage of the current high interest rate environment while generating income. The strategy requires opening multiple CD accounts, each with different maturity dates. The idea is that you always have a CD that reaches maturity and pays interest. Here’s a look at today’s CD rates.
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A financial advisor can help you decide which investments best meet your financial goals. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and provides marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
Jeremy Suschak, CFP®, is a SmartAsset financial planning columnist who answers reader questions about personal finance topics. Do you have a question that you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Jeremy is a financial advisor and head of business development at DBR & CO. He has received compensation for this article. Additional author resources can be found at dbroot.com.
Please note that Jeremy is not a participant in the SmartAsset AMP platform, nor an employee of SmartAsset, and has been compensated for this article. Some reader-submitted questions have been edited for clarity or brevity.
Photo credit: ©iStock.com/Viorel Kurnosov, ©iStock.com/Sam Edwards
The post Ask an Advisor: I Have $1 Million and Want It to Work for Me. How do I maximize passive income and minimize taxes? first appeared on SmartReads by SmartAsset.
