MoneyRates Blog

This tax season, many conservative investors are reaping at least a small reward from low interest rates on CDs, money market accounts, and savings accounts:

With interest rates so low, the income tax on that interest income may be dramatically lower. For people who are in high tax brackets, the difference in tax because of low bank rates can be quite significant.

More generally, income taxes are something that every conservative investor must consider when choosing to invest in bank deposit accounts that pay interest, such as CDs and savings accounts.

The value of that interest income can, depending on your personal tax situation, be eaten into by high tax rates. Interest income, after all, is taxed at the ordinary income rate. There is no lower special tax rate as there currently is for dividends or capital gains income.

For taxpayers who report other income from wages, pensions, or social security, the tax on interest income can reach up to 45 percent between federal and state income taxes.

Painful!

Conservative investors will want to keep a sharp eye, too, on the possible increases in tax rates that may be just around the corner. The higher income tax rates of tomorrow may render the higher bank rates of tomorrow less satisfying (although still, in truth, much to be hoped for).

According to the recently released FDIC Quarterly Banking Profile, bank deposits rose by 13.5 percent, or $641 billion, in 2009. Savings accounts and CDs are selling well with a public that’s tired of being buried in ever-mounting piles of consumer debt.

Businesses have also been putting increasing amounts of money into bank deposit accounts. Bank of America, for example, reported an increase of 24 percent in commercial deposits, to a total of $133 billion.

Under normal circumstances, it might be expected that banks would be lending out these deposits and/or seeking high returns through trading operations. But the uncertain economy has made both borrowers and lender beware. Politically, meanwhile, banks have been under a lot of pressure to stop trading with deposit money–thus the renewed interest in the Glass-Steagall “wall” between deposits and trading activities.

All this begs the question:

What are banks doing with all those deposits? They’re not lending as much, and they’re not trading as much, so what are they doing?

The answer appears two-fold:

1. Shoring up their capital positions, i.e. making sure that the bank is in a strong enough position to withstand the rash of non-performing mortgages, credit card loans, auto loans, etc. that is steadily developing.

2. Investing in low interest rate U.S. Treasury bonds.

In other words, banks may not be paying the highest rates on CDs and savings accounts right now, but neither are banks getting that great of a return on this money. Is that any consolation for low bank rates?

The Senate recently passed a job-creation package which is expected to add $130 billion to the federal budget deficit over the next year and a half. There was a time, of course, when $130 billion would have been considered a pretty sizable deficit all on its own….

The Senate’s action highlighted the somewhat mixed populist message being generated these days — create jobs and reduce the deficit. Naturally, the two are somewhat contradictory, at least in the short term, so it comes down to a choice of doing one or the other.

MoneyRates.com is interested in comments from readers as to what they’d prefer to see done. First though, a bit of analysis:

For the MoneyRates.com audience of bank depositors, the choice between a jobs creation bill and deficit reduction is not clear cut. Even assuming you don’t stand to benefit directly from a job creation bill, employment growth is a key piece in making the economic recovery sustainable. Since the deep recession caused the record low bank rates of the past year or so, stimulating a stronger recovery may seem like the best road to higher bank rates.

On the other hand, failure to get the deficit under control could ultimately erode confidence in the US dollar and thus lead to inflation. Higher savings account rates, money market rates, or CD rates would be meaningless if they were outstripped by even higher inflation rates. So, easy as it is to favor job creation intuitively, in the context of high deficits the costs could be considerable.

So what do you think — is job creation the right way to go, or do you think the emphasis should be on deficit reduction? We are interested in your comments.

Market interest rates moved up smartly in the last month of 2009, but since then they’ve been stuck in a rut. Since bank rates are ultimately likely to follow market interest rates, the recent lack of progress for interest rates means that bank rates are likely to stay stuck in the same rut.

Yields on 10-year U.S. Treasury bonds have been bouncing between 3.55% and 3.85% more most of this year so far. The good news is that periodic declines have been checked before rates fell too far. The bad news is that rates haven’t been able to break through on the upside. Last week was a bit of a recovery week, as rates edged back up to around the 3.70% level after a steep drop the week before.

The lack of a sustained direction in interest rates reflects indecision about the strength of the economy. Economists generally agree that the U.S. is out of recession, but few observers seem very confident about the length and vitality of the economic recovery. Oddly enough, stock investors seem to be more optimistic, as stocks have had quite a strong run since the end of January. However, until that optimism about the economy spreads to the bond market, there won’t be support for a sustained move higher in interest rates.

This means that finding higher bank rates still comes down to smart shopping. On MoneyRates.com, you can find savings account rates, money market rates, and CD rates that are considerably higher than the national averages. Until the market starts to move, your best shot at higher bank rates is to actively look for them.

Conservative investors who are hoping for higher CD rates need to be on the look-out for price increases that may be lurking just around the corner.

Richard Barrington pointed out yesterday how holders of savings accounts and CDs must consider rising oil prices a threat to the value of those savings accounts and those CDs.

But oil prices are not the only potential lurking price increases. Countless American businesses are awaiting the day when the U.S. economy improves enough for some “pricing power” to return to goods and service providers.

As of now, businesses from carmakers to tax preparers are fearful of raising prices because their customers simply cannot afford to pay higher prices. To be blunt, most everyone is quite broke at the moment.

This general brokeness benefits people who have money saved up in savings accounts and CDs in the sense that the dollars held in those accounts have a lot of purchasing power in the current economic environment. Even though deposit account rates are low, it’s not like prices of the things you would buy are going up too much.

If, however, the economy improves, especially the job market, you can expect that many businesses will raise prices ASAP.

This is one reason why we’ve repeatedly blogged about the wisdom of setting up a low cost lifestyle as much as possible, rather than focusing exclusively on getting the best rates on savings accounts and CDs.

Yes, the income side of your personal balance sheet matters immensely, but the expenses column makes or breaks many an American household.