Cash and cash equivalents such as CDs, savings accounts, and money- market funds, are core parts of most asset allocations, as anchors to limit portfolio volatility and safe harbors from choppy markets. But cash is the least tax-efficient investment. Bank interest and money market dividends are taxable as ordinary income immediately as earned, and there’s scant opportunity to profit from lower capital-gain rates.
Fortunately, there are tax-advantaged alternatives to traditional banks and money markets. Your choices turn mostly on what you’re doing with your interest income—spending it or saving it.
If you’re spending your interest income as you earn it:
- Treasury money market funds invest solely in Treasury securities. These are free from state income tax.
- T-bills (Treasury bills issued at a discount and maturing in less than 12 months) aren’t taxable until maturity.
- Tax-free money market funds buy short-term municipal bonds. These are free from federal income tax. They may also be fully or partially free from state income tax, depending on whether you buy a national fund or a single state fund.
- Immediate annuities pay partly in the form of tax-free return of principal.
If you’re accumulating interest as part of a growth portfolio:
- Fixed annuities and variable annuity fixed accounts work like a tax- deferred CD.
- A variable annuity money market fund is a money market fund in a tax- deferred wrapper. High contract charges may erase the advantage of tax deferral. But low-load or no-load contracts offer tax deferral with lower charges.
- IRAs and qualified plans offer money market options.
It may seem like a waste of tax deferral to hold cash in tax-deferred accounts. But the key is to shelter your least efficient investments. If taxable money market funds make more sense than tax-free funds, then a retirement account may be the place to hold your cash. There’s no problem exiting cash investments because there’s no capital gain when you sell. Just find a tax-deferred alternative and transfer your assets.
If you have any questions regarding tax-smart cash choices, please do not hesitate to contact us.