With $1 million, how can I maximize passive income and reduce taxes?

I have a million dollars and I want to put it to work for me. Where can I put it to get the most passive income from it? Also, how can I minimize taxes on these so I can keep more money?

– Andrea

While the current high interest rate environment has been challenging in many ways, the bottom line is that investors looking to earn passive income can do so more easily than they could at any time since the global financial crisis of 2007-2009.

Before laying out some options for capitalizing on prevailing returns and considering the associated tax consequences, it’s helpful to assess your existing financial picture and ask yourself some important questions that will impact where you put your money. (A financial advisor can help you do both, and this tool can help match you with one.)

Assess your financial situation

Your $1 million investment to generate passive income may very well be the best option for that money. However, rather than viewing your decision in a vacuum, I’d recommend looking at money in the context of your larger financial situation and long-term goals. In particular, it may be useful to consider the following questions:

• Your total assets: Already have an investment portfolio? Where are those assets located and what are their tax implications (eg, IRA, Roth IRA, 401(k), brokerage account)?

• Your work status: How many more years will you have income to add to your assets?

• Other income: Do you have other sources of income (Social Security, pension, etc.)?

• Purpose of generating passive income: Are you retired and want to finance your current expenses? Or is it to provide additional income while the rest of your portfolio continues to grow?

• Growth vs. Income: Are you willing and/or able to sacrifice growth and preservation of purchasing power for the sake of income? If income is the only goal or need, then growth expectations and your ability to maintain the purchasing power of assets should remain low.

After thinking about these questions, you may want to pursue a different goal for your money. (And if you need more help assessing your financial situation, consider talking to a financial advisor.)

Options for generating passive income

With interest rates rising from March 2022, income-oriented assets have become more attractive for those looking to earn a reasonable return on their investments. Building a portfolio that includes a variety of assets capable of generating an aggregate return is often a sound approach, as opposed to investing in a single product or security. While a financial advisor can help you build a solid portfolio, here are some options to consider:

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Money market funds

Although generally considered an alternative to holding cash in a savings account, money market funds have become a popular topic among investors amid rising rates. Before the Federal Reserve’s recent spate of interest rate hikes, money market yields were close to 0%, meaning you effectively earned no interest on your investment. Today, however, yields are closer to 5%, which which makes it a much more compelling option for low-risk income generation.

Municipal bonds

Municipal bonds are another solid option for income-focused investors. As with any investment, you’ll want to consider your goals before investing in municipal bonds, as the risk profile and income potential will vary by security. Evaluating credit ratings and maturities against the return you expect to get in exchange for taking on the credit and duration risk is a necessary step to take. Because they are usually not subject to federal taxes (or state taxes in the state in which 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 in popularity as rates have risen. CDs can be especially attractive if you don’t need to liquidate the investment within the intended time horizon, since you’ll generally pay a penalty for early withdrawals. So it’s important to line up a CD’s maturity date with when you expect to need the money back.

Dividend Stocks

If you’re going to need growth to accompany the passive income your money is generating, you might want to consider investing in dividend stocks. The S&P 500 High Dividend Index was paying a dividend yield of more than 5% at the end of September, making it competitive with other listed options. Unlike fixed income products, dividend stocks will typically 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 additional options to generate passive income. These include treasuries, high yield bonds, master limited partnerships (MLPs), real estate investment trusts (REITs) and more. Before committing to each, consider the level of risk you are able and willing to take, the amount of income you will need and whether an element of growth is required. Also, evaluate the tax implications of the investments you choose. (And if you need more help evaluating and selecting investments, consider matching with a financial advisor.)

Mitigation of the impact of taxes

Each of the options mentioned above is treated differently for tax purposes. Interest earned on fixed income securities is taxed at ordinary income tax rates. Taxes on equity dividends depend on how long you hold the asset – qualified dividends are taxed at long-term capital gains rates, while ordinary dividends are taxed at ordinary income rates. Equity appreciation is taxed at capital gains rates.

It is important to understand the tax treatment of individual assets as this will play a role in determining the type of account that holds these assets. 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 usually advisable to hold individual stocks, bonds and index funds in taxable brokerage 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 efficient securities from a fiscal point of view, such as high-yield bonds.

Thinking holistically about the assets you own and where to allocate them will ultimately help you reduce your taxes. Of course, 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 matching with a financial advisor with tax expertise.)

Conclusion

Positioning assets to generate passive income is a sound strategy, but only if it aligns with your long-term financial needs and goals. Before committing to this approach, critically evaluate your personal situation and rationale behind seeking passive income. From there, you can consider various fixed income products, such as bonds and CDs, as well as equity securities, such as dividend-paying stocks. Each option has its own tax consequences, and the type of account in which the securities are held will also impact taxes.

Tips to generate passive income

• A CD ladder is a way to capitalize on the current high interest rate environment while also generating income. The strategy involves opening multiple CD accounts, each with different maturity dates. The idea is that you will always have a CD that comes to maturity and pays interest. Here’s a look at today’s CD rates.

• A financial advisor can help you decide which investments are most aligned with your financial goals. Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool matches you with up to three verified financial advisors serving your area, and you can have a free introductory call with your matched advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help reach your financial goals, get started now.

• Keep an emergency fund handy in case you face unexpected expenses. An emergency fund should be liquid — in an account that isn’t exposed to significant fluctuations, such as the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But a high interest account allows you to earn compound interest. Compare savings accounts from these banks.

• Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with prospects and offers marketing automation solutions so you can spend more time converting. Learn more about SmartAsset AMP.

Jeremy Suschak, CFP®, is a SmartAsset financial planning columnist who answers readers’ questions about personal finance topics. Have a question you’d like answered? Email [email protected] and your question may be answered in a future column.

Jeremy is a Financial Advisor and Head of Business Development at DBR & CO. He was compensated for this article. Additional resources from the author can be found at dbroot.com.

Please note that Jeremy is not a participant in the SmartAsset AMP platform nor is he an employee of SmartAsset and has been compensated for this article. Some questions submitted by readers are edited for clarity or brevity.

Photo credit: ©iStock.com/Viorel Kurnosov, ©iStock.com/Sam Edwards

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