Elevated interest rates have been a top story since 2022. Higher interest rates create multiple planning opportunities, challenges, and solutions.
Getting the most out of your cash reserve. It is important to keep enough cash in a checking or savings account with a local bank branch to cover monthly expenses. Beyond that, if access to cash is the primary concern there are various online banks providing good interest rates for high-yield money market accounts. These accounts pay interest rates that have floated in the four to five percent range recently. Typically, depositors can access this money within 24 to 48 hours, depending on the bank. The downside to the high-yield accounts is the rate is not locked in for any period. If the Federal Reserve cuts interest rates, most likely money market rates will come down fairly quickly. However, money put into a CD or Treasury bill, which also offer rates around 5%, could be locked in for different terms. The downside to CDs is that the interest is taxable in most states, while Treasury interest is not.
Borrowing in the current interest rate environment. Depending on the scope of the need to borrow, ideally, an individual would use some of their cash reserves first rather than borrow at high interest rates. However, there are various situations where the amount of money needed requires taking on a loan. Refinancing rates are definitely elevated, as are lines of credit, but there is plenty of supply (companies willing to lend) making it prudent to try multiple lenders for the best rates. Previously, with rates low, refinances were often done with the first provider. In today's market it is best to get multiple quotes to make sure the rate is competitive.
There are also ways to get more creative when borrowing. For example, family financing may be a good option. If a family member has money to lend this interest rate environment is to their benefit. However, there are some IRS rules that must be followed.
Another option is to borrow from a retirement plan. Many plans allow participants to borrow up to $50,000 from each plan. Normally, this is an option to avoid, but at today’s interest rates a 401k loan may have a 9% interest rate that is paid to the 401k rather than to a bank. Each plan has its own rules and restrictions. Some plans reduce the contributions to the plan by the payment amount until the loan is paid back. These loans are typically the Prime Rate plus one or two percent so the interest rate paid to the plan may be in-line with the return expectations on other investments.
2024 tax penalties have increased because of higher interest rates. Some people are beginning to receive letters from the IRS and State tax agencies that show they owe an underpayment interest penalty. This is when the correct tax withholding was paid but not soon enough in the year. This can happen when taxes are owed throughout the year, but the withholding isn’t enough each quarter to cover the tax, or when there is a balance in April and it's large enough to trigger these penalties which are essentially interest on the amount that should have been paid in.
For 2024, the interest rate used to calculate the underpayment penalties has increased to nearly eight percent. Typically, if a taxpayer owed an interest penalty in the past the amount has been relatively minor, but that may not be the case in 2024 as the underpayment interest penalty has reached a level that has not been seen in some time.
Nearing or in retirement and wanting to protect principle. Typically, as someone nears retirement, they want to take some risk out of their retirement portfolio. In addition, it may be advantageous to take advantage of higher rates by implementing multi-year cash plans to de-risk a portfolio and lock in today’s higher interest rates for the next few years. In the process the portfolio risk can be reduced while the potential return remains fairly competitive given the higher interest rates on lower-risk investments.