Money market accounts are variable-rate savings products. Most yields today are somewhere between 4% and 5.3%. That sounds like a nice return, but — there always is a but — there are two things to keep in mind: taxes and the prevailing inflation rate.
Two problems with money market yields
If the money market is held in a taxable account, the interest earned is taxed as ordinary income. For an investor with a money market account paying 5.3% and paying a combined 30% federal and state income tax rate, he or she will have an after-tax yield of 3.71%. However, that is before inflation. The U.S. inflation rate — measured by the CPI — as of the end of June was 2.97%. If we subtract the inflation rate from the after-tax yield, we get a real after-tax yield of 0.44%. In other words, a 5.3% yield looks enticing, but after taxes and inflation, we’re not really accomplishing much.
The other problem is today’s current income tax rates are set to expire at the end of 2025. What tax rates will be in 2026 is hard to forecast, but several provisions are set to expire. The Tax Foundation notes, “Without congressional approval, most taxpayers will see a notable tax increase.” That may mean more taxes owed on money market interest.
A further problem with money markets is today’s “hot” rates may not be around for that much longer. We haven’t seen rates this high since 2006- 2007. Even then, higher rates didn’t last that long. After 2008 rates stayed low for the next 14 years. How long will rates stay high is up for debate. A recent Financial-Times Chicago Booth poll has the Fed making one quarter-point interest rate cut this year. CNBC recently reported the “dot plot” of rate cuts indicates four reductions in 2025 totaling 1 percentage point. Still, it is anyone’s guess, and forecasts will be adjusted as the data comes out. The point is don’t get too comfortable with today’s rates, because we might have reached peak money market yields.
One solution
All this points to the two major concerns with money markets right now — taxes and variable rates. Of course, investors can buy long-term certificates of deposit to lock in the yield for longer, but the interest is still taxable. Municipal bonds can pay tax-free interest, but there is principal risk. A better approach may be a fixed deferred annuity.
A fixed deferred annuity is an insurance product that guarantees an interest rate for a set number of years. An example may be a fixed deferred annuity with a guaranteed rate of 4.9% for five years. The investor can lock in today’s rates for longer.
The other advantage of a fixed deferred annuity is the interest is tax-deferred. The interest accrues and no taxes are paid until withdrawn. This is unlike a CD or money market where both are fully taxable if held in taxable accounts.
What to know
One of the biggest downsides with a fixed annuity is the illiquidity. Generally speaking, fixed annuities come with surrender penalties. A surrender penalty is assessed when you withdraw money early — within the first five years if you purchased a five-year contract. Surrender penalties vary and can range from 7% of the pre-mature withdrawal in the first year to 3%-5% in year five and zero after year five. For this reason, you want to make sure you won’t need the money for the time period. Most carriers offer a 10% free annual withdrawal, which allows you to withdraw 10% of the contract each year without surrender penalties.
For qualified annuities (those purchased with pretax funds, such as 401(k)s and IRAs), withdrawals are taxed as ordinary income. For non-qualified annuities (purchased with after-tax funds), the earnings portion of your withdrawal is taxed as ordinary income. In both cases, there are also IRS penalties if you withdraw from an annuity prior to age 59½.
Money in a fixed deferred annuity is not FDIC insured, but backed by the insurance carrier, so picking a good quality insurance company is important.
Most fixed annuities have costs designed into the contract. These costs are not netted from the guaranteed rate, but rather built into the contract, so 100% of the money you put into a fixed annuity goes to work from day one. Beyond the surrender penalties, there may be other administrative fees or charges for optional benefits. It’s best to consult with a qualified professional before making any purchase, and shopping around can help ensure a competitive rate.
Final thoughts: Building a diversified fixed-income portfolio
Don’t get me wrong, I still believe in municipal bonds, Treasury bonds and other fixed income investments, and I use them with my clients, but I wouldn’t bank on money markets being the sole source of return. If you peel back the onion, the after-tax and after-inflation yields may not be that attractive. Fixed annuities at least have the ability to defer taxes and lock in today’s rates for longer, unlike money markets whose rates are not guaranteed and can be fully income taxable. CDs may pay similar rates to fixed annuities, but the interest on CDs is taxable each year.
All in all, deferred fixed annuities can be worth considering as part of a diversified fixed-income allocation for tax-conscious investors wanting to lock in today’s interest rates for longer.
For questions or more information, please email the author at maloi@sfr1.com.
Michael Aloi, CFP, is an independent financial advisor with 25 years of experience in helping clients achieve their financial goals. He works with clients throughout the United States. For more information, please visit www.michaelaloi.com.
Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666.
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