By: Reed Fraasa, CFP®, RLP, AIF
The current interest rate environment has driven many to explore high-yield money market accounts and certificates of deposit (CDs) as viable investment vehicles. With interest rates on these instruments at levels unseen in over a decade, it's easy to understand the appeal. However, there is an irony in using these vehicles as long-term investment strategies, especially when compared to the potential tax advantages the stock market offers.
High-Yield Money Markets and CDs: The Tax Burden
Money market accounts and CDs offer fixed returns, making them appealing to risk-averse individuals. While they are often thought of as safe and reliable, their returns are fully taxable as ordinary income in most cases. This means that the interest you earn is taxed at your marginal tax rate, which for many investors can be significant—especially those in higher tax brackets.
For example, if you are in the 32% tax bracket and earn 5% interest on a $100,000 CD, your pre-tax income would be $5,000. But after taxes, you would only be left with $3,400. This reduces the effective yield, meaning the after-tax return on these "high-yield" accounts might not be as high as it seems on paper.
Moreover, money market and CD yields, even in today's higher interest rate environment, rarely outpace inflation over the long term. When taxes are factored in, the real return is often relatively meager. In short, while these options provide short-term liquidity and a sense of security, their tax inefficiency makes them less attractive for long-term wealth building.
The Stock Market: Tax Efficiency and Growth Potential
Now, let's contrast that with the tax treatment of stocks. When you invest in the stock market, you have the potential for income and growth, with favorable tax treatment on both fronts.
First, dividends. While not all companies pay dividends, many do, and some of these dividends qualify as "qualified dividends." These are taxed at the lower long-term capital gains rates, which range from 0% to 20% depending on your income. For most investors, the rate is 15%, considerably lower than the rate on ordinary income. This gives stocks paying qualified dividends a distinct tax advantage over interest from money market accounts or CDs.
Second, capital gains. When you sell a stock for a profit, the gain is taxed, but only at the time of sale. This means you can defer taxes on your gains as long as you hold onto the stock. If you hold the stock for more than a year, your gains are taxed at the long-term capital gains rate, which, like qualified dividends, is typically much lower than your marginal tax rate on ordinary income. This tax deferral is a powerful tool, allowing investments to compound over time without the drag of annual taxation.
Furthermore, unlike interest from CDs or money markets, which are taxed yearly regardless of whether you withdraw the interest, you have control over when to realize capital gains, giving you flexibility in managing your tax liability.
The Irony
The irony is that many individuals focused on protecting their wealth by using CDs or money markets might be subjecting themselves to a higher tax burden than if they had invested in stocks. The perceived safety of guaranteed returns in money markets or CDs often overshadows the long-term wealth erosion caused by taxes and inflation. Meanwhile, while more volatile, the stock market offers mechanisms that can significantly reduce the tax drag on returns through deferred capital gains and preferential tax rates on qualified dividends.
In conclusion, while high-yield money market accounts and CDs offer short-term security, their tax inefficiency makes them less attractive for long-term investing than the stock market, providing opportunities for growth and tax efficiency. Understanding these differences is crucial for anyone looking to build lasting wealth.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.