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Money-Market Accounts: Tax Free or Not Tax Free?
For years, my cash reserves sat in the Vanguard Prime Money Market Fund, a venerable go-to fund, consistently offering top returns with minimal fees. I always thought that nothing could beat it. Then I moved to New York, a high-tax state, and got married. Now, as my wife and I are reevaluating our finances after the birth of our daughter, we realize we can do better. In certain money-market accounts, we actually make more by earning less. How?
Taxes, alas.
You normally have to pay federal income taxes when you earn interest. In New York, we pay a lot of taxes. Turns out that money-market funds that invest primarily in federal, state or municipal securities may generate certain types of income that the tax man doesn’t get.* Our Vanguard fund isn’t one of them though.
Could we do better with a different fund? For a while, I’d been looking for the right online calculator that could help me sort it out. The best I’ve found is from a blog called The Finance Buff.
What, no link? The only thing that was a bit confusing was the calculator’s instructions, so I’ve written some clarifications below. First, read the whole Finance Buff post (the calculator is at the bottom) to review all of the issues at play here. But before you try filling out the calculator, come back here and read on.
Ok, first the post. Now, for filling out that calculator. It’s not completely clear that you don’t have to use just Vanguard funds in the calculator. In fact, you can’t – Vanguard doesn’t offer any AMT Free State-Specific Tax-Exempt funds. Fidelity, however, does offer AMT-free funds. They do so in four (high-tax) states,
One more thing. Finance Buff’s calculator asks “Do you itemize deductions for your state income tax? (no effect if you pay AMT)” We think Buff is asking whether you itemize state income tax on your federal tax return, but we’re not certain. We’ve invited Buff to comment here, just to clarify things.
Besides those quibbles, this thing is really impressive. Don’t know your marginal tax bracket offhand? It includes links to determine federal, state and AMT tax rates. With a few inputs and a click, it generates the after-tax yield and tax equivalent yield for each of up to five different types of money market funds. Amazing!
We chose the Vanguard New York Tax-Exempt Money Market Fund. Its yield of 3.68% is like earning 5.68% before taxes for a New York City resident in the 28% federal tax bracket. Even the mortgage banks offering high interest rates to raise money, including Countrywide and IndyMac, haven’t gone that high.
So, as FiLife launches, please let us know if you find other particularly useful calculators or tools. Perhaps you’ve even built one yourself.
* Some securities can throw off income that is subject to Alternative Minimum Tax (AMT). That’s where AMT-free funds come in, though they may have high minimum investment requirements.
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(3) Comments
Thank you for referring to my post and calculator. I’m glad you found them helpful. You are correct in your notes. Although the post used Vanguard money market funds as examples, the calculator is not limited to Vanguard. The fifth kind, AMT Free state-specific tax-exempt fund, was added so one can compare the Vanguard state specific tax exempt fund (with AMT exposure) to the Fidelity ATM free fund. The calculator is not even limited to money market funds. You can use it for regular bond funds as well.
As for the question “Do you itemize deductions for your state income tax? (no effect if you pay AMT)” perhaps it can be worded better. What I meant was that the state income tax paid is deductible on the federal tax return only if (a) you itemize deductions as opposed to taking the standard deduction; and (b) you don’t pay AMT. Any suggestions?
How much are savings accts taxed (Fed & State?) Is it the maximum % or based on “income” that yr?
thanks
The interest earned in taxable savings accounts is taxed along with other taxable income - wages etc. - at whatever rate that may be.
If you want to think about a maximum %, then you are considering your marginal tax rate on the last dollar. While it may be handy to consider this the rate you are paying on a savings account, it’s not exactly accurate.
