In September, the Federal Reserve raised its benchmark rate by a quarter point, its first increase in three years, and signaled that another hike could come before year-end. The 10-year Treasury yield closed above 5% for the first time in 19 years. Stocks dropped after the announcement and recovered the next day, but many investors have noticed losses on their bond fund statements as yields climbed.
For retirees and pre-retirees in Franklin Lakes and across Bergen County, the bigger story is what higher rates do to your tax bill. More interest income can raise your bracket, your Medicare premiums, and the tax on your Social Security. Lower bond prices can also create tax opportunities that disappear on December 31.
Should I sell my bonds now that rates are rising?
For most investors, no. One Fed decision is rarely a reason to overhaul a portfolio. If you own individual bonds and hold them to maturity, you get your principal back regardless of today’s price, as long as the issuer pays as promised. Defined-maturity bond ETFs work similarly, returning the fund’s assets in a set year. The more useful question is whether your bonds come due, or your bond fund’s duration lines up, with when you will need the money.
Carson’s investment team has expected this environment of solid growth, stubborn inflation, and higher rates. Chief Market Strategist Ryan Detrick has encouraged investors to “diversify your diversifiers,” holding some bonds alongside assets like gold, real assets, and managed futures rather than relying on bonds alone.
Can falling bond prices lower my tax bill?
Yes, if the bonds sit in a taxable account. If your bond fund is worth less than you paid, you can sell it, realize the loss, and immediately buy a similar but not substantially identical fund so your allocation stays intact. That loss can offset capital gains elsewhere in your portfolio, plus up to $3,000 of ordinary income, with any remainder carried forward. Avoid buying back the same fund within 30 days before or after the sale, or the wash-sale rule will disallow the loss.
Pro Tip: Harvest bond losses before year-end, especially if you have gains from a concentrated stock position or a business sale to offset.
Will higher interest income raise my taxes in retirement?
It can, in ways that are easy to miss. Taxable bond and money market interest is taxed as ordinary income, and higher yields mean more of it. That extra income can push you into a higher bracket and trigger three other costs:
- Medicare IRMAA surcharges: Part B and Part D premiums are based on your income from two years earlier, and tax-exempt municipal interest counts toward that total.
- Taxation of Social Security: Up to 85% of your benefits can be taxable, and muni interest counts here too.
- The 3.8% Net Investment Income Tax: It applies above $200,000 of modified adjusted gross income for single filers and $250,000 for joint filers, and those thresholds are not indexed for inflation.
Municipal bond interest is generally excluded from the 3.8% tax, but it still counts for Medicare and Social Security. A muni-heavy portfolio can still raise your Medicare premiums.
Are municipal bonds or Treasuries a better fit for New Jersey residents?
It depends on your bracket. Treasury interest is exempt from New Jersey income tax, which has a top rate above 10%. Interest from New Jersey municipal bonds is generally exempt from both federal and New Jersey tax. To compare a muni to a taxable bond, divide the muni yield by one minus your federal tax rate. In the 32% bracket, a 3.5% muni equals about 5.15% on a taxable bond, before counting state tax savings.
Which accounts should hold my bonds?
Taxable bonds generally belong in a traditional IRA or 401(k), where the interest is tax-deferred. Munis belong in taxable accounts, since the IRA already provides the tax break.
Consider a retired couple in Franklin Lakes who hold a corporate bond fund in their brokerage account and stocks in their IRA. They pay federal and New Jersey tax on that bond interest every year. By holding the bond fund in the IRA instead and moving stocks to the brokerage account, they can lower their annual tax bill without changing their overall mix of stocks and bonds. With the bonds now in the IRA, letting interest collect as cash can also help cover required minimum distributions without selling stocks in a down market.
The Bottom Line
Higher rates are good news for retirees who rely on income, but only the after-tax income pays the bills. On a hypothetical $500,000 bond allocation, improving after-tax yield by half a percentage point adds $2,500 a year. Also do not forget that many of these moves, from harvesting losses to managing income for Medicare, have a December 31 deadline.
Want to see how rising rates affect your taxes and income plan? Schedule a complimentary call with a member of the Carson Wealth Franklin Lakes team.
This material is for informational purposes only and is not tax or investment advice. Please consult your financial and tax professionals about your specific situation.
