For many individuals, certificates of deposit (CDs), savings accounts, and money market accounts are considered conservative financial vehicles. With predictable returns, federal insurance through the FDIC (up to applicable limits), and no exposure to market volatility, these options may seem like reliable choices for short-term savings. However, one important consideration often overlooked is how these vehicles are taxed.
Understanding the tax treatment of interest-bearing accounts can help individuals evaluate whether these accounts align with their overall financial strategy.
How Interest Income Is Taxed
Interest earned from CDs, money market accounts, and traditional savings accounts is generally taxed as ordinary income. This means it is taxed at the same rate as wages or salary—not at the lower capital gains rates that may apply to certain types of investments held for over a year.
Depending on your income, this tax rate could be as high as 37% at the federal level, not including any applicable state income tax.
- CDs and Tax Timing
Interest earned on a CD is taxable in the year it is accrued—even if the CD hasn’t matured and the interest hasn’t been paid out yet. This can result in a tax liability without a corresponding cash benefit in the short term. - Savings and Money Market Accounts
Interest earned in these accounts is also fully taxable in the year it is received. For households with significant cash balances, interest income may contribute to a higher overall tax bill, especially in states with income tax.
A Closer Look at After-Tax Returns
Consider a hypothetical example: An individual places $100,000 in a CD earning 5% interest annually. At the end of the year, they have earned $5,000 in interest. If they fall in the 32% federal tax bracket, they may owe $1,600 in federal income tax on that interest—bringing their net return to approximately 3.4%. State taxes could reduce this further, depending on location.
When evaluating these outcomes alongside inflation and purchasing power, it becomes important to explore additional options that may be more tax-efficient.
Alternative Strategies That May Help Improve Tax Efficiency
A diversified financial strategy may include other instruments that offer more favorable tax treatment or potential for long-term growth:
- Tax-Advantaged Accounts
Retirement accounts like traditional and Roth IRAs can allow investments to grow either tax-deferred or tax-free, depending on the account type. - Tax-Efficient Investment Options
Long-term investments in certain mutual funds, exchange-traded funds (ETFs), or stocks may qualify for long-term capital gains treatment, which is generally taxed at a lower rate than ordinary income. - Municipal Bonds
Municipal bond interest may be exempt from federal—and in some cases, state—income tax, making them a more tax-aware choice for generating income. - Insurance-Based Strategies
Some life insurance policies include features that allow for tax-deferred accumulation of value, with the possibility of accessing funds in a tax-advantaged manner when structured appropriately. (Note: Riders may incur an additional cost and may not be available in all states.)
Final Thoughts: Evaluating All Aspects of a Financial Decision
CDs and bank accounts have their place in a sound financial strategy, particularly for preserving principal and meeting short-term needs. However, understanding the impact of taxes on overall returns is essential. Exploring alternatives that align with your goals and risk tolerance—and that may reduce your tax burden—can be a valuable step in building a more efficient strategy.
If you’re interested in reviewing the tax characteristics of your current holdings or exploring options that align with your broader financial goals, consider working with a financial professional who can help guide you through the decision-making process.
– Jim DesRocher
James Desrocher, Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 800 WESTCHESTER AVENUE, 4TH FLOOR SUITE N409, RYE BROOK NY, 10573, 914-2888800. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. TRUEVIEW FINANCIAL LLC is not an affiliate or subsidiary of PAS or Guardian. 7679266.1 Exp 03/27
This material is intended for general use. By providing this content Park Avenue Securities LLC and your financial representative are not undertaking to provide investment advice or make a recommendation for a specific individual or situation, or to otherwise act in a fiduciary capacity.
The primary feature of whole life insurance is the death benefit. All whole life insurance policy guarantees are subject to the timely payment of all required premiums and the claims paying ability of the issuing insurance company. Policy loans and withdrawals affect the guarantees by reducing the policy’s death benefit and cash values. Some whole life polices do not have cash values in the first two years of the policy and don’t pay a dividend until the policy’s third year. Talk to your financial representative and refer to your individual whole life policy illustration for more information. Dividends are not guaranteed. They are declared annually by Guardian’s Board of Director.
All investments involve risks, including possible loss of principal. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.