How to Avoid Overpaying Tax on Cash Investments
While investment planning requires much more than IRS considerations, make sure you’re not paying too much in tax
Cash investments are another way that investors can balance out their portfolios with safe, predictable options. These offer stability in returns, as they don’t fluctuate with the stock or bond markets. However, because there is low risk, returns are fairly low as well. And managing cash investments efficiently means deferring or reducing taxes when possible – but many people don’t realize the money they could be saving just by altering their investment strategy.
When coming up with tax-efficient strategies for your cash investments, there are several things to consider. First, what kind of cash investments are there? What type of cash investments will allow you to pay the least tax? And what are the advantages and disadvantages of each?
Remember, that while tax savings shouldn’t be the only or governing factor of your investment planning, it’s important to understand ways to avoid overpaying taxes on cash investments.
Here’s an overview of which options are best for varying situations and the tax implications of each.
Types of cash investments
First, let’s take a look at traditional savings accounts. Basic bank savings accounts consist of taxable income that earns taxable interest, and usually unlimited withdrawals can be made. But the interest income made can’t be tax-deferred and must be paid now at the current tax rate.
The same goes for CDs, which are also issued by banks. These savings accounts typically have higher interest rates than standard savings accounts, but there’s usually a set date of maturity and a fixed interest rate, and the funds aren’t as accessible.
Frankly, these types of bank savings accounts are not tax-efficient investments. Even if you don’t cash out the interest income earned and it is added to the account’s principal instead, those earnings are still taxable when they are accrued.
Next: money market funds. Interest income received from these accounts is also taxable when it’s earned, similar to bank savings accounts. However, where these differ is that if you invest in treasury money market funds from U.S. Treasury securities, income received is not taxable at the state and local level. Municipal money market funds are also free from taxes, both at the federal level and (usually) the state and local level as well.
Treasury bills are short-term investments, with less than one year of maturity, and are not taxable at the state and local level. These bills are bought at a discount from face value, and the longer the maturity date, the higher the interest rate the investor receives.
While federal taxes do apply to these, you can actually defer tax at year end with the right strategy. For example, if you purchase the bill in the fourth quarter and the maturity date is in the first quarter of the next year, you can avoid paying taxes until the year of maturity.
Tax-deferred accounts offer investors the option to defer taxes as long as the funds stay in the accounts. Examples include standard 401(k) and 403(b) accounts and traditional IRAs. These are beneficial for tax reasons because income tax rates are usually lower during retirement, when you will be withdrawing the funds from these accounts. So, you’re avoiding the higher income tax rate that you’d be paying on this income right now.
Annuities and variable life insurance accounts are also tax-deferred. Tax-deferred annuities actually have no contribution or distribution requirements from the IRS, as some tax-advantaged accounts do.
With whole life insurance policies, common in retirement planning, cash grows tax-deferred, and you only pay tax on dividends received that exceed the total premiums you’ve paid. And you don’t have to pay tax until you surrender your policy
Putting a significant amount of cash into standard bank savings accounts is not the most tax-efficient option, though many people do it. Especially if you spend the interest as it accrues on your cash, consider investing it in a money market fund – either treasury or municipal. And if you’re saving funds to be used down the road, a tax-deferred account can be a great way to go.
When you’re ready to take a look at your overall investment portfolio, our experienced team is here to help you make the right decisions that will allow you to avoid overpaying on taxes. At Provident CPA & Business Advisors, we ensure that you are making tax-efficient decisions and can help you earn as much as possible on your investments.
Contact us today to learn about long-term tax strategies and how to take advantage of different cash investment options available to you.
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