Higher taxes and lower interest rates follow. What the counselors say to do

Savers who have relied on high interest rates for the past two years could be in for a shock, some financial advisers say.

Not only is the return on their cash likely to decline as a result of the Federal Reserve’s recent interest rate cut, but due to the upcoming expiration of the Trump tax cuts at the end of next year, they could be taxed more on the interest they earn.

“Raising income taxes means less money in the paycheck,” said Brian Large, partner at Lenox Advisors. “Lower interest on your cash means you’re losing returns, plus (that lower) interest will be taxed at a higher rate. This will affect savers across the board.”

What are Trump’s tax cuts?

The Tax Cuts and Jobs Act of 2017 (TCJA), also known as the Trump tax cuts, was the largest overhaul of the tax code in 30 years. It included widespread tax cuts for businesses and individuals. Many of the benefits for individuals expire at the end of 2025.

One of the most significant changes for most Americans included lower income tax rates. The maximum rate decreased from 39.6% to 37%, the 33% decreased to 32%, the 28% decreased to 24%, the 25% decreased to 22%, and the 15% decreased down to 12%. The smallest category remained at 10%, and the 35% remained unchanged.

If the income tax cuts are not extended, the affected brackets will return to pre-TCJA levels.

“At the end of the day, almost everyone will increase their tax rate,” said Mark Steber, tax director at tax preparer Jackson Hewitt.

Why are savings rates falling?

With inflation trending lower, the Fed has turned its attention to ensuring that the labor market remains robust.

Job growth cooled this year as 23-year high interest rates slowed the economy and the pace of price increases. To reinvigorate the labor market, the Fed cut its benchmark short-term fed funds rate in September for the first time in more than four years by half a percentage point.

Banks quickly followed suit, lowering the interest rates they pay customers who hold cash in savings, money market accounts and certificates of deposit (CDs).

With economists forecasting more rate cuts in the coming months, savers who have been collecting up to 5% interest on risk-free cash will likely have to look elsewhere for similar returns, Large said.

Fee discounts and program discounts: Reaganomics or trickle-down theory: Reagan’s impact on today’s economy

How can Americans counter higher taxes and lower interest rates?

• First, Americans should consider taking advantage of current income tax rates before they potentially increase in 2026 by accelerating income in 2024 and 2025 if they can, advisers said.

The story continues

For example, retirees may want to withdraw a little more than the required minimum distribution during these years, said Nayan Lapsiwala, director of wealth management at Aspirant.

Others might consider a Roth conversion to save money by paying lower tax rates now and no fees when withdrawing from Roth accounts later, he said.

• With declining yields in fixed-income holdings like savings accounts, CDs, money market accounts and bonds, consider moving some cash into stocks, Large said.

Not only will stocks typically generate higher returns than fixed-income holdings, those gains will also be taxed at a lower rate, advisers said.

That’s because fixed income interest is taxed as income, but earnings on stocks are taxed as capital gains. Income tax rates are already higher than capital gains rates and are likely to rise even higher after 2025, when Trump’s tax cuts expire.

For assets held for at least one year, capital gains tax rates currently range from 0% to 20%, compared to income tax rates of 10% to 37%.

It’s true that stocks can carry more risk, but the risks can be mitigated by using, for example, mutual funds or exchange-traded funds (ETFS) made up of a range of companies or sectors, advisers said.

In the current context of falling interest rates, companies’ borrowing costs follow. This tends to favor small and medium-sized firms, which have room to grow and may have more financial upside for investors than their larger peers. When companies can afford to borrow more to invest in their businesses, that can lead to higher profits and higher returns on their stocks, Large said.

In addition, money market funds hold a record $6.42 trillion, according to the latest data from the Investment Company Institute. As rates continue to fall, advisers said they expect investors to seek better returns on that money, and stocks will benefit.

The best way to invest in smaller, lower-risk companies is to buy an index like the Russell 2000, which includes companies from a range of industries, Large said.

This approach, however, may not work for everyone, especially seniors who may need a regular income. In that case, Daniel Milan, managing partner at Cornerstone Financial Services, said you’re buying high-quality stocks with dividend growth. Dividends provide regular income while stocks appreciate.

“Dividend growth is the key,” he said. “Dividend growth, annually, must be at or above inflation” for the dividend to be worthwhile. Dividends are taxed as income unless the shares have been held for at least a specified minimum period, which can vary but is usually several months. In this case, the dividend is taxed at the lower capital gains rate.

Milan said he is looking for 7% to 10% annual dividend growth from a stock that has an average yield of 3.5% to 4% a year.

Medora Lee is USA TODAY’s money, markets and personal finance reporter. You can reach her at [email protected] and subscribe to our free Daily Money newsletter for personal finance tips and business news every morning Monday through Friday.

This article originally appeared on USA TODAY: Higher tax rates, lower interest rates: How to handle it