Do you pay interest income on your tax return? If you answered “yes,” what if I told you that there are ways to manage that interest income?
Often, if you’re paying interest income taxes, it’s because you’re either not taking the appropriate risk or aren’t managing your money well. Money doesn’t care about anything other than its own productivity.
And paying taxes on your money is a highly inefficient use of your money.
We’re going to discuss these two reasons you’re paying interest income on your taxes in detail and key strategies to help you eliminate this tax burden.
2 Reasons You’re Paying Interest Income on Your Tax Return
1. You’re Not Taking Appropriate Risk
Risk is personal and subjective. You may be willing to take on immense risk if the reward is high enough. What complicates this is what you consider high risk might be something someone else, like your spouse or financial advisor, considers medium risk. Thus, trying to quantify risk is difficult and in some cases impossible.
That being said, regardless of your risk tolerance, you have to take a hard look at your decisions. For example, if you take zero risk and leave your money in a savings account, you’ll:
- Pay tax on this interest income
- Earn very little interest
Unfortunately, risk management, in this case, isn’t being performed properly. In the ideal world, the risks equal the rewards. However, risk also changes over time. When you’re young and still generating income, you can often take on more risk.
But the closer you get to retirement, the less risk you can take. For example, many people nearing retirement when the pandemic hit took money out of the markets and held it in cash due to extreme volatility.
These individuals could not risk losing a significant portion of their retirement. The risks were too high.
Of course, you might have a different view of risk, and instead of pulling your money out of your accounts, you kept it in and experienced a 30%+ drop in stock value. Alternatively, many investors capitalized on low stock prices, and they bought even more shares. Many stocks returned to their previous highs a few months later, while others struggled throughout the year.
As mentioned before, your risk is personal, but it needs to be managed to maximize your investment accounts while also helping minimize your tax burden.
Once you know your risk tolerance, it’s time to start managing your money. We’ll dive into that now.
2. Your Money Isn’t Well Managed
You may also be paying interest income on your tax return because your money isn’t well managed. Perhaps you have so much money that you have excess cash and don’t care. But with proper management, your money can be productive and reduce or even eliminate your interest income.
Whether you have $5 million or a few thousand dollars sitting in a low-interest savings account, it’s not working for you. Rather than just paying taxes on your interest income, you could instead take the interest earned and invest it in a more productive way.
Let’s talk about some of those ways now.
Strategies to Help You Avoid Taxes on Interest Income
If you receive $10 or more in interest income, you’ll receive Form 1099-INT or 1099-OID. You’ll need to include these forms with your tax returns and pay taxes on the interest earned. However, there are ways that you can lower or eliminate your interest income.
Note: The right strategy depends on your overall risk tolerance and financial goals. However, the strategies below are often used to pay as little on your interest income as possible.
Roth IRA or Roth 401(k)
A Roth IRA account or 401(k) are tax-exempt accounts that allow you to invest money and never pay taxes on the interest earned. However, you do have to conform to the withdrawal rules to avoid taxes on anything these accounts earn. Withdrawals:
- Must be taken after 59 ½
- Must be taken following a five-year holding period
However, there are some exceptions to these rules, too. For example, you can take money out of your Roth IRA for adoption, college expenses, or your first home purchase.
If you expect to pay for academic expenses at any time in your life, consider placing assets into education-oriented accounts. A few accounts to consider are:
- 529 plans
- Coverdell education savings accounts
Assets in these accounts are state income tax-free and can continue to grow tax-free with one caveat: the earnings must be used for academic expenses. If you plan on paying for your child’s or grandchild’s education, leverage one of these accounts to spend less on taxes. We often see these accounts over-funded, so call us for advice on how to make this work for you.
Investors can also invest assets into tax-deferred accounts. However, there’s also the issue that you’ll pay taxes on these accounts eventually. For example, you can put your money into a traditional IRA or 401(k), but you’ll need to pay taxes on these accounts at some point.
What’s the risk here?
You may have to pay higher taxes in the future. If taxes do rise between now and when you reach retirement, you’ll be paying the higher rate when you do withdraw funds.
Municipal bonds often go overlooked, but they allow you to invest in your hometown. Additionally, you may benefit from triple-tax-exempt treatment.
What is triple-tax-exempt-treatment?
This is a fancy way of saying that the interest you receive is exempt on the:
- Federal level
- Municipal level
- State level
Invest in U.S. Treasuries
Treasury securities are another way to avoid state income taxes. These investments can include:
- T-Bills: These government bonds have the shortest range of maturities. Bills auctioned on a regular schedule have terms of 4, 8, 13, 26 and 52 weeks.The cash management bill is issued on variable terms, typically a matter of days. T-bills are issued mature at par value and at a discount.
- T-Notes: These bonds have maturity terms of 2, 3, 5, 7 and 10 years. Interest is paid semi-anually.
- T-Bonds: Also know as the long bond. T-bonds mature in 30 years, and interest is paid semi-annually.
Interest earned on U.S. treasury investments is tax-exempt at the state and local levels, but taxable at the federal level.
If your risk tolerance is low and you’re looking for a way to reduce interest income at the state and local level, U.S. Treasury securities may be a good option.
Paying interest income on your tax return is often unnecessary. You want your money to work for you, and one of the best things you can do is find ways to eliminate interest income. Opening up tax-exempt accounts or investing in the right financial vehicles will allow you to grow your money and avoid costly taxes
To learn more about how KPN Enterprises can help you avoid paying taxes on interest income, reach your financial goals, or to schedule a call, contact us here.