Savings Account or Money Fund: Does Tax Change the Winner?

Take two made-up accounts. A savings account pays 3.90%. A Treasury money fund pays 3.60%. The savings account looks better by 0.30 points. In a state with a 9% income tax, the fund keeps more. This chapter shows why, and how to check your own state in about a minute.

What does a Treasury money fund have to do with tax?

A Treasury money market fund is a fund that holds short-term U.S. government debt. You buy shares, and the fund pays you its interest as dividends.

Federal law says U.S. government obligations are exempt from taxation by a state or local government (31 U.S.C. 3124). The IRS says interest on Treasury bills, notes and bonds is taxed by the federal government but exempt from state and local income tax. A savings account has no such exemption. Your state taxes that interest like other income, if your state has an income tax.

Federal tax applies to both accounts at the same rate. So federal tax drops out of the comparison. Only your state rate decides which account keeps more.

How do you compare the two?

Use two steps. First, multiply the savings rate by one minus your state rate. That is what the savings account keeps. Second, compare it with the fund's rate, which the state does not tax.

The table uses made-up yields: 3.90% for savings and 3.60% for the fund. The dollars are per $10,000 for one year. The 3.07% row is Pennsylvania's flat income tax rate, from the state revenue department. The other rows are made-up state rates.

The two tie when the state rate is about 7.69%. Above it, the fund wins with these yields. The gap is small either way. At 9%, a $50,000 balance keeps $1,800 in the fund and $1,774.50 in savings, so the fund is $25.50 ahead.

What savings rate do you need to match the fund?

Divide the fund's rate by one minus your state rate. The result is called the tax-equivalent yield. It is the savings rate that leaves you the same dollars after state tax.

At 9%, your savings account must pay at least 3.96% to beat a 3.60% fund. The made-up 3.90% falls short.

Use your marginal rate, which is the rate on your next dollar of income. Do not use your average rate or the state's top rate. If your city or county also taxes income, add that rate. In a state with no income tax, the exemption is worth nothing, and you can compare the two rates as they are.

Is the whole fund dividend exempt?

Not always. Only the part that comes from U.S. government obligations is exempt. A fund that also holds other assets passes less through. The Liquidity chapter on state tax also reports that some states set a minimum share before they allow any exemption.

Suppose only 80% of the fund's dividends qualify, in the same 9% state. The fund then keeps $353.52 per $10,000, not $360.00. The savings account keeps $354.90, so the savings account wins by $1.38. The fund's yearly tax statement gives the real share. Do not assume it is 100%.

What else should you weigh?

The gap in these examples is small, a few dollars per $10,000. Other things can matter more.

• Insurance. The FDIC insures deposit accounts at insured banks, at least $250,000 per depositor at each bank. A money market fund is not a bank deposit. The FDIC says mutual funds are not covered.
• Fees. A fund's yield is the amount after its fees. Compare the yield the fund reports, not a headline rate.
• Paperwork. You enter the exempt part of the dividends on your state return yourself. Your tax software will ask for the figure from the fund.
• Moving. A fund usually sits at a brokerage, not a bank. Moving money there has its own steps.
• Federal deduction. If you itemize, your state tax may also reduce your federal tax. That changes the break-even slightly. The Liquidity chapter on state tax covers the two cases.

What should you do next?

1. Find your marginal state income tax rate on your state revenue department's site.
2. Divide the Treasury fund's yield by one minus that rate.
3. Compare the result with the savings rate you can really get.
4. If the fund is ahead, look up its yearly Treasury share before you count on the whole exemption.
5. If the gap is a few dollars, let insurance, fees and convenience decide.

Limits of this guide.

• Every yield and every state rate except Pennsylvania's 3.07% is made up. Check live rates before you act.
• This is not tax advice. Rules differ by state and by fund, and they change.
• The math assumes federal tax is the same on both accounts and ignores fund fees beyond the reported yield.