Tax season is underway. Here’s what investors should know to prepare

Published Thu, Feb 1 20241:59 PM EST

Tax filing season officially started on Monday, and investors could pay the price following last year's stock market bonanza. While the deadline to file a 2023 tax return and pay sums owed is April 15, January tends to be when taxpayers receive the documents necessary to file, including their W-2 from their employers and an array of Form 1099s from banks and brokerages. Last year was spectacular for investors, with the tech sector driving the S & P 500 to a 24.2% gain. Meanwhile, investors collected yields exceeding 5% in money market funds, certificates of deposit and high yield savings accounts. "You should expect to see a higher level of interest income than you did the year before, given the same portfolio," said Tim Steffen, CPA and director of advanced planning, private wealth management at Baird in Milwaukee. "Given the market performance last year, especially coming off a down year, if you had an actively managed account, you might see more short-term gains than you had in recent years." "That can be much more expensive from a tax standpoint," he said. Here's what to expect. Surprise taxable interest With last year's high yields, it's easy for investors to find themselves on the hook for taxes on this interest. To make matters worse, this taxable interest – be it from bonds, CDs or high-yield savings accounts – is treated as ordinary income, which can be subject to a tax rate as high as 37% at the top marginal rate. "I think interest is going to be the big issue, and it's material," said Brenna McLoughlin, certified financial planner and senior advisor at Wealthstream Advisors in New York. She noted that one client who couldn't resist higher yields on CDs in 2023 saw a 15% boost in their taxable investment income. "These 1099s are coming through with materially higher taxable interest numbers and people overlook that," she said, referring to the Form 1099-INT financial institutions submit to customers if they receive at least $10 of interest in a given year. The silver lining is that investors who need a place to park their cash for the short term – but would rather do it without a big tax hit – may want to consider parking some of that money in Treasury bills instead. Interest from Treasurys is subject to federal income taxes, but it is exempt from state and local income levies. "In New York and California, it can make a big difference on the bite off the interest you've earned this year," said McLoughlin. In New York, the top income tax rate is 10.9%, and it's 13.3% in California. Money market fund investors who captured attractive yields in 2023 are also on the hook for taxes, but going forward they can mitigate the hit by shifting to a municipal money market fund. This way, the interest income is free from federal taxes. There are also state-specific muni money market funds for residents in high-tax states. Vanguard's New York Municipal Money Market Fund (VYFXX) has a 7-day SEC yield of 4.25% and an expense ratio of 0.16%. Fidelity offers the California Municipal Money Market Fund (FSPXX) , which has a 7-day yield of 3.54% and an expense ratio of 0.3%. Being mindful of asset location Investors who adopted a longer-term mindset and invested in corporate bonds – rather than sticking around in cash – may want to think about whether they held those assets in a taxable account or a tax-deferred account (like an individual retirement account or a 401(k)). By placing these corporate bonds in a tax-deferred account, you can hold off on the tax hit for interest paid. "If you don't place these assets in the appropriate accounts, your after-tax return is much lower," said Sam Nofzinger, general manager of brokerage at Public. Muni bonds, however, belong in taxable accounts, so that investors can take advantage of their tax-free income. Stocks and funds that spin out qualified dividends – which are subject to a top rate of 20% – might be a better fit for brokerage accounts. Just be aware that whether you reinvest the dividend or spend it down, you're still subject to taxes on that income. "A reinvestment of dividends doesn't preclude the taxes today," said Steffen. The difference is that by reinvesting the dividend, you build your basis in the position – and that can result in a smaller capital gain when you sell in the future. Reining in taxes from your stock positions Investors who actively managed their stock holdings last year, capturing winners in the tech space, will want to be mindful of how long they held a position before selling it. That's because if you held an asset for more than one year before you sell it, it's subject to long-term capital gains treatment – a rate that can run as high as 20%. If you dispose of an asset you've held for less than one year, it's a short-term capital gain and subject to the same treatment as ordinary income: a top rate of 37%. "If you're days away from going long term, maybe hold onto that asset," said Nofzinger. There's a lesson for investors who may have taken gains off the table in 2023: Had they sold some of their biggest losers in 2022 – when the S & P 500 fell 19.4% – they could have carried forward those tax losses and worked with their accountant to apply them to capital gains incurred in 2023. "When the market is down, it feels unpleasant, but if you can book the loss and stay invested, you get this tax benefit that will help you in future years," said McLoughlin.