Savers who have enjoyed high interest rates in recent years may face challenges ahead, as financial advisers warn of potential changes in both taxes and interest rates, USA Today reports.
The Federal Reserve’s recent rate cuts, along with the upcoming expiration of tax cuts enacted under the 2017 Tax Cuts and Jobs Act (TCJA), may lead to lower returns on savings and higher taxes on the interest earned.
The Federal Reserve reduced its benchmark interest rate in September 2023, marking the first cut in over four years. This move was aimed at supporting the labor market, which has shown signs of slowing down as inflation trends lower. However, this change has caused banks to lower the interest rates offered on savings accounts, money market accounts, and certificates of deposit (CDs). Savers who have benefited from interest rates as high as 5% in recent years will likely need to explore other investment options to maintain similar returns.
Economists predict further rate cuts, which could continue to reduce savings yields. Brian Large, a partner at Lenox Advisors, noted that lower interest rates could reduce returns, and these reduced returns will still be subject to taxes—likely at higher rates as tax policies shift.
The TCJA, passed in 2017, introduced widespread tax cuts for individuals and businesses. For individuals, the most significant changes included reductions in income tax rates, which expire at the end of 2025. Without legislative action, tax brackets will revert to pre-2017 levels, meaning higher taxes for many Americans. For example, the top tax rate will increase from 37% back to 39.6%, while other brackets will also see similar upward shifts.
Mark Steber, chief tax officer at Jackson Hewitt, cautions that “almost everyone’s tax rate will go up” unless the cuts are extended. This tax increase would directly impact savings, as interest earned on savings accounts and other fixed-income investments is taxed as regular income, subject to those higher rates.
Financial advisers recommend several strategies to help Americans navigate the upcoming changes:
- Accelerate Income: Individuals who can should consider accelerating income in 2024 and 2025 before the tax rates rise. For retirees, this may mean withdrawing more than the required minimum distribution from retirement accounts during these years to take advantage of the lower tax rates.
- Roth Conversions: Some individuals may benefit from converting traditional IRAs to Roth IRAs. While this would require paying taxes upfront at the current lower rates, future withdrawals from Roth accounts are tax-free, providing a potential advantage after tax rates increase.
- Shift to Stocks: As interest rates fall, returns from savings accounts and CDs will decline. Advisers suggest shifting some cash into stocks, which historically offer higher returns than fixed-income investments. Importantly, earnings from stocks are taxed at the capital gains rate, which is lower than the income tax rate and may remain more favorable even after tax increases in 2026.
For assets held for at least a year, capital gains tax rates currently range from 0% to 20%, depending on income, compared to income tax rates that go as high as 37%.
- Consider Dividend Stocks: For those who need regular income, dividend-growth stocks may be a good option. Daniel Milan, managing partner at Cornerstone Financial Services, advises looking for stocks with annual dividend growth of 7% to 10%, yielding around 3.5% to 4%. This growth can help keep pace with inflation, and dividends, if held long enough, can also benefit from the lower capital gains tax rate.
- Invest in Small and Mid-Sized Companies: As interest rates drop, companies’ borrowing costs decrease, which can be especially beneficial for small and mid-sized firms. These companies often have more room for growth and may offer higher returns for investors. Large suggests investing in indices like the Russell 2000, which includes a wide range of smaller companies.
While the combination of higher taxes and lower interest rates presents challenges, there are steps Americans can take to protect their savings and grow their wealth. Accelerating income, converting to Roth accounts, shifting to stock investments, and focusing on dividend growth are all strategies that financial advisers suggest considering before the landscape shifts.
