With the Fed continuing its interest rate increases, most investors are now parking their cash on the sidelines either in money market funds or short-term 6-month treasuries for ~4.5 to 5% interest income yield. Even Ray Dalio who is often quoted as saying, “Cash is Trash” has recently stated that holding cash is relatively attractive! In fact, with yields between 4.5-5%, there could be an argument made in the short-term that it is even more attractive than dividend ETFs because the interest that you earn is risk free! However, what is often not discussed is that beginner investors should not just look at the distribution yield but actually calculate the after tax income dollars they would receive from the distribution payments because the after tax payout differences could be meaningful for both interest income and dividends.
Comparing After-Tax Income of Money Market Accounts
As an example, we will compare the after tax interest income of two money market funds (Vanguard’s VMFXX and VYFXX) over the last 9 months in the chart below. Different money market funds may have different distribution yields and these may fluctuate month-to-month depending on each fund’s cash flow dynamics.
Both funds typically increase their distribution yields in line with the Fed Funds effective rate, however, two key dynamics need to be considered:
- Fund-specific cash flow dynamics may affect monthly payout yields. When there is a significant amount of investors that funnel their cash into select money market funds, the portfolio manager may need to adjust the distribution yield to be lower for a given month as it now suddenly needs to payout more interest to more investors, thus, lowering the distribution yield per investor. However, the opposite is also true. When investors exit a fund or withdraw their cash, the fund manager may look to raise the distribution payout yield to reward existing investors for keeping their cash with the fund.
- Tax-exempt yields are often less than taxable money market yields. Since tax-exempt money market funds can be tax-exempt either at the federal and / or state local levels, the yields will be lower compared to the “pre-tax” yields that are stated by the taxable money market funds. Therefore, its best to always calculate and compare the estimated post-tax payments to understand what’s most beneficial to you depending on your tax situation.
Let’s assume that you live in NYS and you have ~$1M that you want to invest in either VYFXX and VMFXX and your federal income tax bracket is 37% and NYS income tax rate is 6.85%. If we use the historical distribution yields over the last 9 months, you can see that depending on the fluctuating distribution yield, the post-tax interest may favor either VMFXX or VYFXX depending on the month. Based on the last 9 months, there are more times where VYFXX would have paid you more in post-tax income than VMFXX.
Because its difficult to predict where the yields will land, our approach has been to take a hybrid approach to optimize our allocation of our cash across both VMFXX and VYFXX depending on the maximum total post-tax income. Given today’s latest rates of 4.59% for VMFXX and 3.01% VYFXX, we have a 60% cash allocation to VMFXX and 40% VYFXX.
Besides looking at the marketed yields for the money market accounts, remember to analyze the post-tax income payout so that you are comparing apples-to-apples in this dynamic environment so that you can maximize your short-term post-tax income.
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