Safer investments for earning high yields
Because the Federal Reserve has been increasing interest rates, there are many conservative alternatives available for investors now who want to take advantage of high returns with minimum risks. Here are some of the alternatives available to you and the associated tax issues:
Certificates of deposit
The returns associated with certificates of deposit (CDs) are much higher than they were at the beginning of 2022. You can now invest in five-year CDs and obtain a return of more than 5%. These rates are much higher than they were at the beginning of last year. However, there are penalties if you redeem them prior to maturity.
Interest on CDs is taxed at ordinary income tax rates at the federal and state level. You will owe taxes each year on the interest earned and paid out each year. As you would expect, the rates of return are generally higher for longer-term maturities.
Series I U.S. Savings Bonds
When inflation was at high levels in 2022, returns on these inflation-protected bonds were as high as 9.62%. These rates change every six months based on the changes in the cost-of-living index. Because inflation levels are lower now, the returns for I-bonds are now 4.3%.
There are no state or local taxes on the interest. You incur federal taxes on the interest when you redeem the bonds. You may choose to pay interest annually. If you use the interest to pay for higher education, some or all of the interest may be tax- free.
Money market funds
The returns from money market funds are above 5% now. The earnings are subject to federal and state income taxes.
A significant advantage of these funds is the liquidity. You can obtain high returns without investing on a long-term basis. But, if interest rates in general go down, the interest rate on your money market fund will go down immediately. So, if you want a guaranteed higher rate on a long-term basis, a five-year CD would provide a longer guarantee for a high return.
You can also purchase tax-free money markets, which would not be taxable at the federal level and possibly the state level. The returns on tax-free money market funds will be lower, so your marginal tax bracket will determine whether this alternative is more favorable for you.
Treasury bills are available for 4-, 8-,13-, 26- and 52-week maturities. The 52-week return was over 5.4% at the time I wrote this article. Interest is taxable at the federal level but is generally exempt from state and local taxes.
You can purchase these directly from the U.S. Treasury at TreasuryDirect.gov, your mutual fund or another financial institution. If you purchase bills directly from the Treasury, you can elect tax withholding.
Income from municipal bonds is generally free from federal taxes and taxes in the state where the bonds were issued. The interest rates are generally lower than the returns on CDs and money market funds, so your marginal tax bracket will determine whether municipal bonds make sense for you on an after-tax basis.
Every individual municipal bond issue is rated by financial rating services (Moody’s, S&P and Fitch), and you should restrict your purchase to individual bonds that have high ratings.
Rather than purchase individual bonds, you can buy municipal mutual funds with different maturities. The shorter-term funds have less risk but also lower returns. You can purchase intermediate- or long-term municipal funds with higher returns but also more risk.
There are definitely risks associated with long-term investments in mutual bond funds if interest rates increase. There is less risk associated with municipal bonds if you purchase individual bonds with a fixed maturity, and hold the bond until maturity.
Another alternative, which has much more risk, is purchasing individual stocks or mutual funds with a history of high dividends.
For many years, I have held Vanguard Dividend Appreciation Index Fund Admiral Shares (VDADX) in my portfolio, which invests in companies with a history of increasing dividends. The annualized returns for one year, three years and five years have been 10.75%, 12.61% and 11.4%.
Do not purchase any stock or fund for high dividends on a short-term basis. Investing in equities requires a long-term strategy.
© 2023 Elliot Raphaelson. Distributed by Tribune Content Agency, LLC.