Higher tax rates, lower interest rates coming: How to handle it

Some financial advisers say savers who have banked on high interest rates for the past few years may be in for a shock.

Not only will their cash returns shrink in the wake of the Federal Reserve's recent rate cuts, but thanks to the impending expiration of Trump's tax cuts at the end of next year, the interest they earn could be taxed more.

“Increased income taxes mean less money in your paycheck,” says Brian Large, partner at Lennox Advisors. “Lower interest on your cash means you're missing out on returns, plus, (that lower) interest will be taxable at a higher rate. This will affect savers across the board.”

What are the Trump 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 includes massive tax cuts for businesses and individuals. Many benefits for individuals expire at the end of 2025.

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One of the most significant changes for most Americans is the lower income tax rate. The top rate dropped from 39.6% to 37%, the 33% bracket dropped to 32%, the 28% bracket dropped to 24%, the 25% bracket dropped to 22%, and the 15% bracket dropped to 12%. The lowest bracket remained at 10%, and the 35% tax bracket remained unchanged.

Unless the income tax cut is extended, the affected brackets will revert to pre-TCJA levels.

“At the end of the day, almost everyone's tax rate will go up,” said Mark Steber, chief tax officer at tax preparer Jackson Hewitt.

Why is the savings rate falling?

With inflation trending lower, the Fed has focused on ensuring the labor market remains strong.

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

Banks quickly cut interest rates for customers with cash in savings bonds, money market accounts and certificates of deposit (CDs).

With economists predicting further rate cuts in the coming months, savers who have been collecting up to 5% interest on their cash without risk will likely have to look elsewhere to get a similar return, Large said.

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How can Americans resist high taxes and low interest?

• First, Americans should consider taking advantage of current income tax rates ahead of possible increases in 2026 by accelerating income in 2024 and 2025, advisers said.

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

Others may consider a Roth conversion to save money by paying lower tax rates now and no taxes on later withdrawals from the Roth account, he said.

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

While stocks typically don't generate higher returns than fixed-income holdings, those earnings will be taxed at lower rates, consultants said.

Because fixed income interest is taxed as income, but stock gains are taxed as capital gains. Income tax rates are already higher than capital gains rates and will likely be even higher after Trump's tax cuts expire after 2025.

For assets held for at least one year, capital gains tax rates currently range between 0% and 20%, income tax rates between 10% and 37%.

True, stocks may carry more risk, but those risks can be mitigated by using, for example, mutual funds or exchange traded funds (ETFS) comprised of a range of companies or sectors, consultants say.

In the current environment of falling interest rates, the company's cost of debt follows suit. It favors small and medium-sized companies, which have room for growth and potentially greater financial upside for investors than their larger peers. When companies can borrow more to invest in their businesses, it can drive higher profits and bigger returns in their stocks, Large said.

Also, money market funds have 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 look for better returns on that money and stocks to benefit.

The best way to invest in smaller companies with less risk is to buy an index like the Russell 2000, which includes companies from different industries, Large said.

Although this method may not work for everyone, especially for seniors who may need some regular income. In that case, says Daniel Milan, managing partner at Cornerstone Financial Services, buy high-quality, dividend-growth stocks. Dividends provide regular income while stocks appreciate.

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

Milan said he's looking for 7% to 10% annual dividend growth from a stock that averages 3.5% to 4% a year.

Medora Lee is a money, markets and personal finance reporter at USA Today. You can contact him at mjlee@usatoday.com and subscribe to our free daily money newsletter for personal finance tips and business news every Monday through Friday morning.