Making Sense of Tax Efficient Money Funds

Given the recent slide in interest rates, I’ve begun looking into tax-advantaged options for our cash holdings. We’re currently holding our cash in a combination of savings accounts (mainly HSBC Direct and our new Bank of America Money Market Account) and the Vanguard Prime Money Market Fund (VMMXX).

For the sake of comparison, HSBC Direct is now paying 4.5% 3.55% APY, whereas our Bank of America account offers 4.99% APY, and VMMXX has a compound yield of 5.12%. Of course, these are pretax numbers, and the interest/dividends on these accounts are all taxable. So what other options are out there?

One possibility is the Vanguard Treasury Money Market Fund (VMPXX), which is currently yielding 4.5%. There is also an Admiral version of this fund (VUSSX) which offers high rollers (those with over $50 invested in the fund) a slightly higher compound yield of 4.61%. But wait, it gets better… Because Treasury securities are state tax free, their tax-equivalent yield is a good bit higher.

What’s a tax-equivalent yield?

Good question. In short, the tax equivalent yield allows you to make a fair comparison between taxable and tax-free returns. Here’s the equation:

Tax Equivalent Yield = Tax-Free Yield / (1 – (% Tax Bracket / 100))

Our marginal state income tax rate is 6% so, in the case of VMPXX and VUSSX, the tax equivalent yields work out to be:

4.5% / (1 – 0.06) = 4.79%

4.61% / (1 – 0.06) = 4.90%

Not bad, but these still lag the VMMXX (the Prime Money Market Fund) as well as the FDIC-insured Bank of America Money Market Account.

What about municipal bonds?

Another possibility would be investing in municipal bonds, which are exempt from federal income taxes (and, in some cases, state income taxes, too). While you can invest in such bonds directly, I’m lazy and prefer to use a mutual fund. Like its Treasury and Prime Money Market brethren, the Vanguard Tax Exempt Money Fund (VMSXX) seeks to maintain a share value of $1, making it a rough equivalent of a savings account, albeit without the FDIC backing.

While this fund has a compound yield of just 3.73%, the earnings are exempt from federal income taxes. So what does that mean in terms of a tax-equivalent yield? Well, it looks like we’ll land squarely in the 33% tax bracket this year, so…

3.73% / (1 – 0.33) = 5.57%

Nice. Of course, the benefit here is greatest for those in higher tax brackets – if you’re in the 25% tax bracket, the tax-equivalent yield falls back to 4.97%. And forget about holding such funds in a tax-advantaged account such as a 401(k), 403(b) or IRA – the tax break provides no benefit under such circumstances, so you’re just left with a low yield.

What about the AMT?

One downside of municipal bonds (or municipal bond funds) is that they can increase your exposure to the Alternative Minimum Tax (AMT). More specifically, so-called “private activity” municipal bonds (those that are used to finance things like airports, stadiums, or housing agencies) are federal tax exempt, but not exempt from the AMT.

The AMT is a complex beast that deserves an article (or a series of articles) of its own, but… Suffice it to say that the AMT is a parallel tax system that disallows a bunch of different types of deductions and credits. Basically, you calculate your taxes both ways and pay the larger amount. In the case of the Vanguard Tax Exempt Money Fund, 16.9% of the fund’s income is currently subject to the AMT. As far as I’m aware, however, we don’t have much else in the way of AMT exposure, so I’m hoping that we’ll be okay.

10 Responses to “Making Sense of Tax Efficient Money Funds”

  1. You just have to divide the yield by 1 minus your marginal rate. If you’re in the 25% tax bracket, it’s yield/0.75 — I guess I’m not sure why something that simple needs to be automated.

  2. Anonymous

    nickel: Thanks 🙂 I still think the process is still quite manual though. Why can’t someone take my financial situation, tax situation and then let me know how much yield it will be by going online and comparing the yields and recommending me with the best yield?

  3. MoneyNing: It’s very easy to set up in a spreadsheet. Just make a column for the yield and a column for the marginal tax rate. Then set up the simple equation (above) in a third column.

  4. Ben: The expense ratio is reflected in the yield.

    MFJ: Wrong way to think about it. If you are in the 33% tax bracket, then any dollars you slice off the top (or add on) are subject to a 33% tax savings (or tax hit) until you cross the threshold down (or up) into the next tax bracket. The marginal rate (in this case 33%) is what counts even though you are paying less than that on average.

    It’s the same way with any sort of tax deduction. Tax deduction come “off the top” so they save you money at the full marginal rate.

  5. Anonymous

    Shouldn’t you also take into account your effective tax rate? Even though you will be in the 33% tax bracket your entire income won’t be taxed at 33% so in theory the benefit won’t be quite as great.

    Great analysis I’ve been debating where to go with my money as well. BTW congrats on the 33% tax bracket


  6. Anonymous

    Shouldn’t you take into account the expense ratio on the given fund? In your last example for the Vanguard Tax Exempt Money Fund (VMSXX) it would appear that the expense ratio is 0.13% which drops your effective yield down to 5.37%.

    Or am I misreading — does Vanguard’s compound yield number already take this into account?

  7. Anonymous

    Very detailed analysis. Thank you. To be quite honest I never really took taxes into major consideration, but your examples here show that it can make a pretty big impact depending on your tax bracket. I’m going to start looking into municipal bonds, currently I just throw my cash holdings into my etrade savings account at 5.05APY and some in the ol ING account.

  8. Anonymous

    This is nice analysis. It looks like for many people (those in the 28% tax bracket or lower), it is probably best just to leave their money in a hih yield savings or money market account for now. At least, that is what I will be doing until the rates continue to decrease. If you have a lot of money to invest and are in a higher tax bracket, the Vanguard tax exempt fund you mentioned looks promising.

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