I have a million dollars and I want to put it to work for me. Where can I put it to make the most amount of passive income from it? Also, how can I minimize taxes on that to be able to keep more of that money?
– Andrea
While today’s high-interest rate environment has been challenging in many respects, the silver lining is that investors seeking to earn passive income can do so more easily than they could at any point since the global financial crisis of 2007-2009.
Before laying out some options to capitalize on prevailing yields and considering the associated tax consequences, it’s helpful to evaluate your existing financial picture and ask yourself some important questions that will impact where you put the money. (A financial advisor can help you do both and this tool can help you match with one.)
Evaluate Your Financial Situation
Investing your $1 million dollars with an eye toward generating passive income may very well be the best option for this money. However, rather than viewing your decision in a vacuum, I would recommend looking at the money in the context of your broader financial situation and longer-term goals. In particular, it might be helpful to consider the following questions:
Your total assets: Do you already have a portfolio of investments? Where are those assets located and what are their tax implications (e.g., IRA, Roth IRA, 401(k), brokerage account)?
Your work status: How many more years will you have an income to add to your assets?
Other income: Do you have any other sources of income (Social Security, pension, etc.)?
Purpose for generating passive income: Are you retired and seeking to fund your ongoing expenses? Or is it to provide supplementary income while the rest of your portfolio continues to grow?
Growth vs. income: Are you willing and/or able to sacrifice growth and preservation of purchasing power for the sake of income? If income is the only goal or need, then expectations for growth and your ability to maintain the purchasing power of the assets should remain low.
It is possible that after thinking through these questions you might pursue a different goal for the money. (And if you need more help assessing your financial situation, consider speaking with a financial advisor.)
Options for Generating Passive Income
Given the rise in interest rates since March 2022, income-oriented assets have become more attractive for those looking to earn a reasonable yield from their investments. Building a portfolio that includes a variety of assets capable of generating an aggregate yield is often a sound approach, as opposed to investing in a single product or security. While a financial advisor can help you build a robust portfolio, here are a few options to consider:
Money Market Funds
While generally considered an alternative to holding cash in a savings account, money market funds have become a popular topic among investors amid rate increases. Prior to the Federal Reserve’s recent series of rate hikes, money market yields were close to 0%, meaning you effectively earned no interest on your investment. Today, however, yields are closer to 5%, making this a much more compelling option for generating low-risk income.
Municipal Bonds
Municipal bonds are another solid option for income-focused investors. As with any investment, you’ll want to consider your goals before investing in municipal bonds since the risk profile and income potential will vary across securities. Evaluating credit ratings and maturities in relation to the yield you expect to earn in exchange for taking on credit and duration risk is a necessary step to take. Because they are typically not subject to federal taxes (or state taxes in the state where they are issued), municipal bonds tend to be a tax-efficient investment.
Certificates of Deposit
Like money market funds, certificates of deposit (CDs) have gained popularity as rates have increased. CDs can be particularly attractive if you do not need to liquidate the investment over its intended time horizon since you generally will pay a penalty for early withdrawals. It is therefore important to align a CD’s maturity date with the date at which you expect to need the money back.
Dividend Stocks
If you will need some growth to accompany the passive income your money generates, you may want to consider investing in dividend stocks. The S&P 500 High Dividend Index was paying a dividend yield in excess of 5% as of the end of September, making it competitive with other options listed. Unlike fixed-income products, dividend stocks will typically provide more opportunity for appreciation, which may help you maintain purchasing power over time if that’s a concern.
Other Options
Of course, there are additional options for generating passive income. These include Treasuries, high-yield bonds, master limited partnerships (MLPs), real estate investment trusts (REITs) and many others. Before committing to each, consider the level of risk you are able and willing to take, the amount of income you will need, and whether some element of growth is necessary. Also, evaluate the tax implications of the investments you choose. (And if you need more help evaluating and selecting investments, consider matching with a financial advisor.)
Mitigate the Impact of Taxes
Each of the options cited above is treated differently for tax purposes. The interest earned by fixed-income securities is taxed at ordinary income tax rates. Taxes on dividends from equity securities depend on how long you own the asset – qualified dividends are taxed at long-term capital gains rates while ordinary dividends are taxed at ordinary income rates. Appreciation from equity securities is taxed at capital gains rates.
It’s important to understand the tax treatment of individual assets since that will play a role in determining the type of account that holds these assets. Generally speaking, owning individual stocks and bonds, as well as their passively managed index alternatives, is more tax-efficient than actively managed mutual funds. Therefore, it’s typically advisable to own individual stocks, bonds and index funds in taxable brokerage accounts. Tax-advantaged accounts like IRAs and 401(k)s, and after-tax Roth IRAs, are generally more suitable for your actively managed funds and less tax-efficient securities like high-yield bonds.
Thinking holistically about the assets you own and where to allocate them will ultimately help you mitigate taxes. Of course, it can be helpful to speak with your tax advisor to better understand the impact on your individual situation, given your specific tax brackets. (Consider matching with a financial advisor with tax expertise.)
Bottom Line
Positioning your assets for passive income generation is a sound strategy, but only if it aligns with your long-term financial needs and goals. Before committing to this approach, critically assess your personal situation and the rationale behind seeking passive income. From there, you may consider various fixed-income products like bonds and CDs, as well as equity securities like dividend-paying stocks. Each option has its own tax consequences, and the type of account the securities are held in will also have an impact on taxes.
Tips for Generating Passive Income
A CD ladder is one way to capitalize on today’s high-interest rate environment while also generating income. The strategy calls for opening multiple CD accounts, each with varying maturity dates. The idea is that you’ll always have a CD reaching its maturity date and paying out interest. Here’s a look at today’s CD rates.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid -- in an account that isn't at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Jeremy Suschak, CFP®, is a SmartAsset financial planning columnist who answers reader questions on personal finance topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Jeremy is a financial advisor and head of business development at DBR & CO. He has been compensated for this article. Additional resources from the author can be found at dbroot.com.
Please note that Jeremy is not a participant in the SmartAsset AMP platform, nor is he an employee of SmartAsset, and he has been compensated for this article. Some reader-submitted questions are edited for clarity or brevity.
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