High interest rates mean a boom for fixed income investments, but taxes can be a blast.

Rising interest rates have revived Americans’ preference for fixed-income investments such as bonds and others Money market capitalbut experts warn that they should be prepared for the taxes.

To combat inflationThe Federal Reserve raised its key interest rate, the short-term key interest rate, from 5.25% to 5.50% close to zero at the beginning of 2022 and until Highest value in 22 years.

Higher interest rates hurt consumers who have to pay more for loans, but are a boon for savers who get a higher return on their money, especially given the uncertain economy and volatile stock markets. The assets of money market funds rose to a record high $5.69 trillion in the first three months of this year, Fed data shows.

The higher, steady and almost risk-free However, income can come at a price: You could be faced with a higher tax burden in the new year, experts say.

“On the one hand, it’s great news, you get higher interest rates, but are you ready for a tax increase in April or sooner when you have to make quarterly estimated payments?” said Rob Keller, tax partner at tax consulting firm KPMG.

What are fixed interest investments?

Fixed-interest assets are those with a regular, fixed payout, such as savings accounts, Money market capital, Certificates of Deposit (CDs)or state and municipal bonds. They are generally low-risk income generators.

In a balanced portfolio, they serve to balance out stock holdings that are riskier and usually generate returns through appreciation. A traditional balanced portfolio is 60% stocks and 40% fixed income, aka that 60/40 portfolio.

How are fixed income investments taxed compared to stocks?

Money earned from fixed income assets is counted as income and taxed at your income tax rate, regardless of what tax bracket you fall into. In 2023, the IRS lists seven federal income tax rates between 10% and 37%.

“These are typically higher than dividends and capital gains rates from stocks,” said Omar Qureshi, investment strategist at financial advisor Hightower in St. Louis, Missouri.

The story goes on

The tax rates for qualified stock dividends and capital gains on assets held for at least one year are between 0% to 20%, depending on taxable income and filing status. Most people pay a 15% capital gains tax when selling their shares IRS says.

State taxes may also apply to fixed interest payments. This can be especially bad if you’re in a high income tax state like California or New York, both of which have top tax rates above 10%, advisers say.

“If you are in a high tax bracket, about 50% of your interest income goes back to the government,” Qureshi said. “At first glance, a 5.5% interest rate on your money sounds good, but if you have to give half of it back, that’s not so good.”

Is there a way to mitigate the tax burden?

Yes, think about what you buy and where you keep the assets.

• Investing in a U.S. government-backed security, such as a Treasury bill, note, or bond, allows you to avoid federal tax.

“You still pay federal tax on the interest earned, but if you live in a high-tax state like California, a T-bill could be a great investment because you can save on the state side of the house,” Keller said.

• Municipal bonds issued by state, city and local governments are generally free of federal taxes, to. They are also generally tax-free in the state in which the bond is issued. However, there are exceptions. Therefore, advisors recommend being cautious and checking with an advisor about the rules governing the municipal bonds you are considering.

• Invest in fixed income assets through your tax-free retirement accounts. This means you can now not only skip taxes, but also control if you want to take the money and pay taxes, said JR Gondeck, managing director and partner at wealth management firm Lerner Group.

For those who are risk-averse: Best Low Risk Investments of 2023

Are fixed-interest investments worth it given the tax burden?

Yes. Despite the tax hit, you’ll likely still come out ahead, although not to the extent you expected, advisers say.

“Even if you pay taxes, you still make money,” Keller said. Additionally, “for many taxpayers, getting 5.5% interest is good.” Not every taxpayer pays the highest marginal (income) tax rate, and perhaps they live in a state like Texas with no (income) tax.”

What else should I know about fixed income investing?

Since not all fixed income assets are created equal, you need to do your homework. For example:

• Government bonds are the safest because they are 100% guaranteed by Uncle Sam, so you can get back your original investment at any time, but money market funds are neither guaranteed nor FDIC insured, meaning you could lose your entire investment. However, money market accounts and CDs are FDIC insured up to $250,000.

• Municipal bonds are not as easy to sell as government bonds if you want to get rid of them because they are issued in much smaller amounts.

• While CDs are easier to buy than Treasurys − Treasury bonds must be purchased directly from the government, but CDs can be purchased from banks, credit unions, and brokers − CDs require careful management. The rate you set for the CD only applies for the term of the CD. If the CD rolls automatically, it may do so at a slower speed. Or if you pay it out early, fees may apply. There are no fees for paying out a government bond.

Medora Lee is a money, markets and personal finance reporter for USA TODAY. You can reach them at mjlee@usatoday.com and sign up for our free Daily Money newsletter every Monday for personal finance tips and business news.

This article originally appeared on USA TODAY: High interest rates encourage fixed-interest investments, but beware of taxes!