Gordon Gottsegen
Ultra-wealthy investors know how to position their investments to minimize taxes, and individual investors can do the same with bonds.
It feels good to have a high-paying job. It's exciting to watch the money you've invested grow over time. But it feels terrible to have to pay some of that money back come tax time.
Savvy investors know how to position their investments to minimize future tax burdens, which can be accomplished by taking advantage of tax loss harvesting or trading in tax-advantaged accounts like Roth IRAs.
But in today's market conditions, investors have another way to make money while minimizing the tax impact: by investing excess cash in tax-exempt bonds.
See also: How to invest in bonds like a pro
Over the past two years, the Federal Reserve has raised interest rates to historically high levels, meaning that for the first time in over a decade, people can earn significant amounts of money by receiving interest on their savings. This has led to an explosion of interest in certificates of deposit (CDs) and high-yield savings accounts.
Unfortunately, this interest is subject to tax.
“Millions of people across the country are putting billions of dollars into high-yield savings accounts, and some accounts, like our high-yield savings product, are currently paying 5%. That's a lot of money, and a lot of certainty,” Boris Hentoff, Betterment's senior vice president of product strategy and sustainable investing, told MarketWatch.
Betterment is a digital investment company that, like many of its competitors, offers high-yield savings accounts to attract customers. But after high-yield savings accounts exploded in popularity last year, Betterment said many customers were surprised by the taxes they paid on those accounts.
“Until very recently, it was little known that this source of income was taxed, and in fact, it is taxed at very unfavourable rates.”
Interest income is taxed just like any other income, such as income from a job. So if you have $10,000 in a high-yield savings account that earns 5% annual interest, you'll owe tax on that $500 in interest whether you withdraw it from the account or not.
On top of that, interest is taxed at your federal income tax rate, meaning the more you earn, the larger percentage of that $500 you'll pay in tax.
This is a potential drawback for high-income earners who just want to earn interest on their excess cash, and according to Betterment, many people don't realize the drawbacks until tax season arrives and they're in debt.
But the company also saw the increased attention on taxes as an opportunity to launch tax-advantaged products.
Betterment announced Thursday that it is partnering with Goldman Sachs (GS) to launch the Tax-Smart Bond Management Portfolio, which will provide investors with exposure to a variety of bond ETFs to minimize taxes depending on their specific tax situation. The portfolio is set up to give investors a safe place to park their cash, similar to a high-yield savings account, while also investing in Treasury and municipal bonds for tax benefits and corporate bonds for yield enhancements, according to the company.
Investment bank Goldman Sachs is known for serving high-net-worth individuals, corporations and other groups that manage large amounts of cash. Placing investments to minimize clients' tax burdens is nothing new for the firm. What's new is that companies like Betterment are offering these services to a broader range of individual investors.
“We're in a high interest rate environment right now, and income tax management is suddenly a huge opportunity,” Hentoff said. “This wasn't invented yesterday. High net worth individuals and institutions understand that untaxed income is worth more per dollar. Suddenly, there's an opportunity for individual investors to leverage.”
It’s worth noting that individual investors can invest in Treasury and municipal bonds on their own and generate the low-risk, tax-free returns these assets are known for. In fact, many individual investors are doing so. U.S. households are investing in Treasury bonds at record rates.
Betterment calculates an investor's specific tax situation and designs a bond portfolio to generate returns while minimizing tax impacts, which means taking into account an individual's income bracket, where they live, etc. Betterment says its portfolio product is for individuals who earn more than $191,000 and are in the 32% marginal tax bracket.
Higher-income earners can benefit more from investing in tax-exempt bonds. But no matter what your income is, it's important to know how taxes will affect your portfolio and savings.
For some people, a high-yield savings account may be a good place to park excess cash. But depending on an individual's situation, investors may be shooting themselves in the foot by doing so.
-Gordon Gottsegen
This content was produced by MarketWatch, an operation of Dow Jones & Co. MarketWatch is published independently of Dow Jones Newswires and The Wall Street Journal.
(End) Dow Jones Newswires
07-19-24 0730ET
Copyright (c) 2024 Dow Jones & Company, Inc.
