Harry Sit's Blog, page 14

June 5, 2023

Buying CD in a Brokerage Account vs Bank CD or Treasury

Buying CDs in a brokerage account doesn’t require opening a separate account with a bank. Is it worth it?

Table of ContentsWhat Is a Brokered CDHow a Brokered CD WorksBrokered CD vs Direct CDEverything In One AccountCompetitive RatesNo Renewal TrapCall RiskCan’t Withdraw EarlyReinvestment RiskBrokered CD vs TreasuryYield May Be LowerNo State Tax ExemptionTreasuries Aren’t CallableLarge Haircut When You SellWhat Is a Brokered CD

When you see CDs offered in your Fidelity, Vanguard, or Charles Schwab account, they’re brokered CDs. A brokered CD is issued by a bank and sold through brokers.

The CD has FDIC insurance. If you have other money at the same bank that issues the CD, your FDIC insurance limit is aggregated across your direct holdings and your brokered CDs from that bank.

A brokered CD is safe as long as you stay under the FDIC insurance limit. I bought a brokered CD from a bank in Puerto Rico during the 2008 financial crisis. FDIC paid me in full with interest when that bank failed. I didn’t have to file any claim. The cash just showed up in my account about a week after the announced bank failure.

How a Brokered CD Works

Except for having FDIC insurance, a brokered CD works more like a bond.

1 CD is $1,000 of principal. You buy them in $1,000 increments. Fidelity offers “fractional CD” at $100 increments on some CDs. Brokers typically don’t charge fees for buying brokered CDs or holding them in your account. You will see fluctuating prices for the CD after you buy it in your brokerage account but you’ll be paid the full face value when it matures.

Brokered CDs don’t compound. Interest payments from the CD are paid into your brokerage accounts as cash. The payment frequency varies depending on the CD. It can be monthly, quarterly, or semi-annually. Some short-term CDs only pay interest at maturity. If the interest rate on a brokered CD is 5% and it pays semi-annually, you’ll receive $25 in interest per $1,000 of principal every six months.

You get the principal back as cash when the CD matures. If you want to get out of the CD before it matures, you must sell it on the secondary market to another buyer.

Brokered CD vs Direct CD

Brokered CDs have some advantages over CDs you buy directly at a bank or a credit union. They also have two large disadvantages.

Everything In One Account

It’s more convenient to buy brokered CDs from several different banks in one brokerage account than to open a separate account at each bank. This is helpful especially when you buy short-term CDs, but if you’re considering a 5-year CD, you only open an account once when you buy directly from a bank or a credit union and you’re good for five years.

Competitive Rates

Because banks know that brokers present brokered CDs in a table sorted by the yield, they have to offer a competitive yield to show up on top. They can’t prey on customers not being up to speed on the going rates. Many banks still offer very low rates on their websites but they have competitive rates on brokered CDs.

Not all banks offer brokered CDs though. Some banks, and especially credit unions, offer CD specials only to their direct customers. You should check the best rates on DepositAccounts.com to see whether a bank or a credit union offers a better rate than the rate you see from a brokered CD.

No Renewal Trap

By default, a brokered CD is automatically cashed out when it matures. Some brokers offer an “auto roll” feature to buy another brokered CD of the same term when one CD matures but you specifically sign up for that feature only if you want it.

Most banks and credit unions automatically renew a matured CD. The new CD they renew you into often has a low rate. You’ll have to tell them to stop the renewal within a short window. If you aren’t on top of it, you’ll either be stuck with a low rate or you’ll have to pay a big early withdrawal penalty that can eat into your principal. See Beware: Banks Auto-Renew CDs with a Short Window to Back Out.

Call Risk

Many brokered CDs are callable, which means the bank has the right to terminate (“call”) the CD before the stated maturity date.

Having your CD terminated prematurely is the opposite of you refinancing your mortgage when the market rate goes down. The bank has the choice to terminate the CD or not. You have no right to refuse.

Some callable CDs have preset dates when the bank may exercise its right to terminate. Some are continuously callable, which means the bank has the right to terminate at any time after a certain date.

Naturally, the bank will only terminate the CD when the going rate goes down. You were counting on earning the guaranteed interest for the full term. All of a sudden the bank decides to pay you out early. You get your money back but you can only earn less now because the going rate is lower. On the other hand, if the going rate goes up, the bank chooses not to terminate the CD, and you’re stuck with a below-market rate until maturity.

A callable CD gives you the worst of both worlds. Most direct CDs aren’t callable. You’re guaranteed to enjoy the rate you locked in for the full term when you buy a CD directly from a bank or a credit union. You should compare only non-callable brokered CDs with direct CDs or demand a substantially higher yield from a callable brokered CD.

For example, as I’m writing this, Vanguard shows the best 5-year brokered CD pays 5.2% and DepositAccounts.com shows the best 5-year direct CD from a credit union pays 4.68%. That makes brokerage CDs look attractive until you find out that the brokered CDs with higher rates are all callable.

Callable and Non-Callable CDs

The best rate on a 5-year non-callable brokered CD is only 4.5%. This is lower than the 4.68% yield on a 5-year CD you can get from a credit union. You will have to weigh the convenience of buying a brokered CD against getting a lower yield or taking the call risk.

Can’t Withdraw Early

A CD bought directly from a bank or a credit union has a big advantage over a brokered CD because you can break it by paying a preset early withdrawal penalty. Some direct CDs have no early withdrawal penalty (“no-penalty CDs”).

A brokered CD doesn’t offer an option to withdraw early. You must sell the brokered CD on the secondary market to a bond dealer if you want to get out early.

There may not be a dealer interested in your CD when you want to sell. If there’s a dealer, the price you receive from selling the CD is determined by the current market rate at that time minus a large haircut. It may be much lower than paying the preset early withdrawal penalty on a direct CD.

Breaking a CD isn’t only for an unexpected need for cash. When interest rates go up sharply, it makes sense to pay an early withdrawal penalty and reinvest at a higher yield. I broke all my direct CDs last year by paying the early withdrawal penalty because the CD Early Withdrawal Penalty Calculator shows that I will end up with a higher value than holding the CDs to maturity. I wouldn’t have had this option had I bought brokered CDs.

Reinvestment Risk

When you have a CD directly from a bank or a credit union, you have the option to have the interest paid out to you or to reinvest the interest in the CD. If the going rate goes up, you choose to have the interest paid out and earn a higher yield elsewhere. If the going rate falls, you choose to reinvest the interest at the original higher yield.

You don’t have this option with a brokered CD. All interest is paid out in cash. If the going rate goes down, you can only earn a lower yield on the interest.

Brokered CD vs Treasury

Suppose you like the convenience of brokered CDs and you don’t mind giving up a small difference in yield and the option to withdraw early. Still don’t pull the trigger just yet. You always have the option to buy Treasuries instead.

Brokers sell brokered CDs because they’re paid by the banks to sell the CDs. You see more advertising from the broker for brokered CDs than for Treasuries but you may be better off buying Treasuries anyway.

Because Treasuries have a direct guarantee from the government versus through a separate government agency (the FDIC), brokered CDs must overcome several hurdles before you consider them. Otherwise you just buy Treasuries.

Yield May Be Lower

Brokered CDs don’t always pay more than Treasuries of a comparable term. For example, as I’m writing this, the best six-month brokered CD pays 5.3% APY whereas a six-month Treasury pays 5.4%.

Don’t buy a brokered CD only because the rate sounds attractive on the surface. Always find out first what a Treasury is paying for the same term. See How To Buy Treasury Bills & Notes Without Fee at Online Brokers and How to Buy Treasury Bills & Notes On the Secondary Market. Don’t bother with a brokered CD when a Treasury pays more.

No State Tax Exemption

If you buy in a regular taxable brokerage account, interest from Treasuries is exempt from state and local taxes. Interest from brokered CDs is fully taxable by the state and local governments. Brokered CDs must pay more than Treasuries after adjusting for this state and local tax exemption.

If you take the standard deduction or if you itemize deductions but your state and local taxes are already capped by the $10,000 limit, you don’t get any federal tax deduction for paying additional state and local taxes. When your federal marginal tax rate is f and your state and local marginal tax rate is s, the tax-equivalent yield of a Treasury with a quoted yield of t is:

t * ( 1 – f ) / ( 1 – f – s )

For example, as I’m writing this, the best 1-year brokered CD has a yield of 5.4% and a one-year Treasury has a yield of 5.24%. When your federal marginal tax rate is 22% and your state and local marginal tax rate is 6%, the tax-equivalent yield of the Treasury is:

5.24% * ( 1 – .22 ) / ( 1 – .22 – .06 ) = 5.68%

That means a CD must have a yield of 5.68% to earn the same amount after all taxes as a Treasury with a yield of 5.24%. Although the brokered CD with a yield of 5.4% appears to pay more than the Treasury with a yield of 5.24% at first glance, it actually pays less than the Treasury after you take all taxes into account.

If you itemize deductions and your state and local taxes aren’t already capped by the $10,000 limit, you still get a federal tax deduction for the state and local taxes you pay on the interest from the CD. The tax-equivalent yield formula is:

t / ( 1 – s )

In that case, the CD still needs to yield 5.24% / ( 1 – .06 ) = 5.57% to beat the Treasury.

You don’t have to make a tax-equivalent yield adjustment if you’re buying in an IRA or if you don’t have state and local taxes.

Treasuries Aren’t Callable

Many brokered CDs are callable whereas all Treasuries aren’t callable. You should compare only non-callable brokered CDs with Treasuries or demand a substantially higher yield from a callable brokered CD.

For example, as I’m writing this, Fidelity shows the best 5-year brokered CD pays 5.2% when the yield on a 5-year Treasury is 3.89% but the best yield on a 5-year non-callable brokered CD is only 4.5%.

The yield advantage shrinks further when you adjust the Treasury yield for the state and local tax exemption. If we use the same federal marginal tax rate of 22% and state and local marginal tax rate of 6% in the example above, the tax-equivalent yield of the 3.89% Treasury is 4.21%. The 4.5% brokered CD only has a marginally higher yield than the Treasury. It’s more competitive in an IRA and in no-tax states.

Large Haircut When You Sell

If you want to get out of a brokered CD before it matures, you must sell it to a willing buyer. That’s the same for Treasuries but there are far fewer buyers for brokered CDs than for Treasuries. The buyer for your brokered CD will demand a substantial price concession to take over the CD from you.

Treasuries are highly liquid and competitive. If you must sell your Treasuries before maturity, you may get a lower price than your original purchase price but it’s going to be a fair price based on the market condition at that time.

Any slight yield advantage you have from a brokered CD over a comparable Treasury vanishes quickly if you must sell before maturity. Don’t even consider brokered CDs if there’s any chance you won’t hold them to maturity.

***

Before you explore whether it makes sense to buy a brokered CD, you should:

1. Decide what term you want because selling brokered CDs before maturity will be costly.

2. Check DepositAccounts.com for the best rate on a direct CD for your term. Weigh the convenience of brokered CDs against giving up yield and the early withdrawal option.

3. Check the yield on Treasuries for your term. Adjust it for the state and local tax exemption if you’re buying in a regular taxable account.

4. Only compare non-callable brokered CDs with direct CDs and Treasuries. Demand a large yield difference if you don’t mind callable CDs.

I give a detailed walkthrough of how to buy a CD at Fidelity or Vanguard in the next post: How to Buy CDs in a Fidelity or Vanguard Brokerage Account.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on June 05, 2023 13:23

Brokered CD vs Direct CD vs Treasury: Is It Worth It?

The debt ceiling has been resolved. While it was hanging in the air, you may have come across brokered CDs, which you can buy in a brokerage account without having to open a separate account with a bank. Are they worth it?

Table of ContentsWhat Is a Brokered CDHow a Brokered CD WorksBrokered CD vs Direct CDEverything In One AccountCompetitive RatesNo Renewal TrapCall RiskCan’t Withdraw EarlyReinvestment RiskBrokered CD vs TreasuryYield May Be LowerNo State Tax ExemptionTreasuries Aren’t CallableLarge Haircut When You SellWhat Is a Brokered CD

A brokered CD is a CD issued by a bank and sold through brokers. When you see a CD offered in your Fidelity, Vanguard, or Charles Schwab account, that’s a brokered CD.

The CD is issued by a bank. It has FDIC insurance. If you have other money at the same bank that issues the CD, your FDIC insurance limit is aggregated across your direct holdings and your brokered CDs from that bank.

A brokered CD is safe as long as you stay under the FDIC insurance limit. I bought a brokered CD from a bank in Puerto Rico during the 2008 financial crisis. FDIC paid me in full with interest when that bank failed.

How a Brokered CD Works

Except for having FDIC insurance, a brokered CD works more like a bond.

1 CD is $1,000 of principal. You buy them in $1,000 increments. Fidelity offers “fractional CD” on some CDs. You will see fluctuating prices for the CD after you buy it in your brokerage account.

Periodic interest payments from the CD are paid into your brokerage accounts as cash. They aren’t automatically reinvested into the same CD. You get the principal back as cash when the CD matures. If you want to get out of the CD before it matures, you must sell it on the secondary market to another buyer.

Brokered CD vs Direct CD

Brokerage CDs have some advantages over CDs you buy directly at a bank or a credit union. They also have two large disadvantages.

Everything In One Account

It’s more convenient to buy brokered CDs from several different banks in one brokerage account than to open a separate account at each bank. This is helpful especially when you buy short-term CDs, but if you’re considering a 5-year CD, you only open an account once when you buy directly from a bank or a credit union and you’re good for five years.

Competitive Rates

Because banks know that brokers present brokered CDs in a table sorted by the yield, they have to offer a competitive yield to show up on top. They can’t prey on customers not being up to speed on the going rates. Many banks still offer very low rates on their websites but they have competitive rates on brokered CDs.

Not all banks offer brokered CDs though. Some banks, and especially credit unions, offer CD specials only to their direct customers. You should check the best rates on DepositAccounts.com to see whether a bank or a credit union offers a better rate than the rate you see from a brokered CD.

No Renewal Trap

By default, a brokered CD is automatically cashed out when it matures. Some brokers offer an “auto roll” feature to buy another brokered CD of the same term when one CD matures but you specifically sign up for that feature only if you want it.

Most banks and credit unions automatically renew a matured CD. The new CD they renew you into often has a low rate. You’ll have to tell them to stop the renewal within a short window. If you aren’t on top of it, you’ll either be stuck with a low rate or you’ll have to pay a big early withdrawal penalty that can eat into your principal. See Beware: Banks Auto-Renew CDs with a Short Window to Back Out.

Call Risk

Many brokered CDs are callable, which means the bank has the right to terminate (“call”) the CD before the stated maturity date.

Having your CD terminated prematurely is the opposite of you refinancing your mortgage when the market rate goes down. The bank has the choice to terminate the CD or not. You have no right to refuse.

Some callable CDs have preset dates when the bank may exercise its right to terminate. Some are continuously callable, which means the bank has the right to terminate at any time after a certain date.

Naturally, the bank will only terminate the CD when the going rate goes down. You were counting on earning the guaranteed interest for the full term. All of a sudden the bank decides to pay you out early. You get your money back but you can only earn less now because the going rate is lower. On the other hand, if the going rate goes up, the bank chooses not to terminate the CD, and you’re stuck with a below-market rate until maturity.

A callable CD gives you the worst of both worlds. Most direct CDs aren’t callable. You’re guaranteed to enjoy the rate you locked in for the full term when you buy a CD directly from a bank or a credit union. You should compare only non-callable brokered CDs with direct CDs or demand a substantially higher yield from a callable brokered CD.

For example, as I’m writing this, Vanguard shows the best 5-year brokered CD pays 5.2% and DepositAccounts.com shows the best 5-year direct CD from a credit union pays 4.68%. That makes brokerage CDs look attractive until you find out that the brokered CDs with higher rates are all callable.

Callable and Non-Callable CDs

The best rate on a 5-year non-callable brokered CD is only 4.5%. This is lower than the 4.68% yield on a 5-year CD you can get from a credit union. You will have to weigh the convenience of buying a brokered CD against getting a lower yield or taking the call risk.

Can’t Withdraw Early

A CD bought directly from a bank or a credit union has a big advantage over a brokered CD because you can break it by paying a preset early withdrawal penalty. Some direct CDs have no early withdrawal penalty (“no-penalty CDs”).

A brokered CD doesn’t offer an option to withdraw early. You must sell the brokered CD on the secondary market to another buyer if you want to get out early.

There may not be a buyer for your CD when you want to sell. If there’s a buyer, the price you receive from selling the CD is determined by the current market rate at that time minus a large haircut. It may be much lower than paying the preset early withdrawal penalty on a direct CD.

Breaking a CD isn’t only for an unexpected need for cash. When interest rates go up sharply, it makes sense to pay an early withdrawal penalty and reinvest at a higher yield. I broke all my direct CDs last year by paying the early withdrawal penalty because the CD Early Withdrawal Penalty Calculator shows that I will end up with a higher value than holding the CDs to maturity. I wouldn’t have had this option had I bought brokered CDs.

Reinvestment Risk

When you have a CD directly from a bank or a credit union, you have the option to have the interest paid out to you or to reinvest the interest in the CD. If the going rate goes up, you choose to have the interest paid out and earn a higher yield elsewhere. If the going rate falls, you choose to reinvest the interest at the original higher yield.

You don’t have this option with a brokered CD. All interest is paid out in cash. If the going rate goes down, you can only earn a lower yield on the interest.

Brokered CD vs Treasury

Suppose you like the convenience of brokered CDs and you don’t mind giving up a small difference in yield and the option to withdraw early. Still don’t pull the trigger just yet. You always have the option to buy Treasuries instead.

Brokers sell brokered CDs because they’re paid by the banks to sell the CDs. You see more advertising from the broker for brokered CDs than for Treasuries but you may be better off buying Treasuries anyway.

Because Treasuries have a direct guarantee from the government versus through a separate government agency (the FDIC), brokered CDs must overcome several hurdles before you consider them. Otherwise you just buy Treasuries.

Yield May Be Lower

Brokered CDs don’t always pay more than Treasuries of a comparable term. For example, as I’m writing this, the best six-month brokered CD pays 5.3% APY whereas a six-month Treasury pays 5.4%.

Don’t buy a brokered CD only because the rate sounds attractive on the surface. Always find out first what a Treasury is paying for the same term. See How To Buy Treasury Bills & Notes Without Fee at Online Brokers and How to Buy Treasury Bills & Notes On the Secondary Market. Don’t bother with a brokered CD when a Treasury pays more.

No State Tax Exemption

If you buy in a regular taxable brokerage account, interest from Treasuries is exempt from state and local taxes. Interest from brokered CDs is fully taxable by the state and local governments. Brokered CDs must pay more than Treasuries after adjusting for this state and local tax exemption.

If your federal marginal tax rate is f and your state and local marginal tax rate is s, the tax-equivalent yield of a Treasury with a quoted yield of t is:

t * ( 1 – f ) / ( 1 – f – s )

For example, as I’m writing this, the best 1-year brokered CD has a yield of 5.4% and a one-year Treasury has a yield of 5.24%. When your federal marginal tax rate is 22% and your state and local marginal tax rate is 6%, the tax-equivalent yield of the Treasury is:

5.24% * ( 1 – .22 ) / ( 1 – .22 – .06 ) = 5.68%

That means a CD must have a yield of 5.68% to earn the same amount after all taxes as a Treasury with a yield of 5.24%. Although the brokered CD with a yield of 5.4% appears to pay more than the Treasury with a yield of 5.24% at first glance, it actually pays less than the Treasury after you take all taxes into account.

You don’t have to make this adjustment if you’re buying in an IRA or if you don’t have state and local taxes.

Treasuries Aren’t Callable

Many brokered CDs are callable whereas all Treasuries aren’t callable. You should compare only non-callable brokered CDs with Treasuries or demand a substantially higher yield from a callable brokered CD.

For example, as I’m writing this, Fidelity shows the best 5-year brokered CD pays 5.2% when the yield on a 5-year Treasury is 3.89% but the best yield on a 5-year non-callable brokered CD is only 4.5%.

The yield advantage shrinks further when you adjust the Treasury yield for the state and local tax exemption. If we use the same federal marginal tax rate of 22% and state and local marginal tax rate of 6% in the example above, the tax-equivalent yield of the 3.89% Treasury is 4.21%. The 4.5% brokered CD only has a marginally higher yield than the Treasury. It’s more competitive in an IRA and in no-tax states.

Large Haircut When You Sell

If you want to get out of a brokered CD before it matures, you must sell it to a willing buyer. That’s the same for Treasuries but there are far fewer buyers for brokered CDs than for Treasuries. The buyer for your brokered CD will demand a substantial price concession to take over the CD from you.

Treasuries are highly liquid and competitive. If you must sell your Treasuries before maturity, you may get a lower price than your original purchase price but it’s going to be a fair price based on the market condition at that time.

Any slight yield advantage you have from a brokered CD over a comparable Treasury vanishes quickly if you must sell before maturity. Don’t even consider brokered CDs if there’s any chance you won’t hold them to maturity.

***

Before you explore whether it makes sense to buy a brokered CD, you should:

1. Decide what term you want because selling brokered CDs before maturity will be costly.

2. Check DepositAccounts.com for the best rate on a direct CD for your term. Weigh the convenience of brokered CDs against giving up yield and the early withdrawal option.

3. Check the yield on Treasuries for your term. Adjust it for the state and local tax exemption if you’re buying in a regular taxable account.

4. Only compare non-callable brokered CDs with direct CDs and Treasuries. Demand a large yield difference if you don’t mind callable CDs.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on June 05, 2023 13:23

May 15, 2023

Tax Planning with TurboTax What-If Worksheet: Roth Conversion

The tax season is over for most people but if you used TurboTax downloaded software, don’t uninstall it just yet.

I showed in previous posts some unwelcoming features in TurboTax that you may want to opt out of — underpayment penalty and estimated tax payment vouchers. Ironically, TurboTax downloaded software also has a very useful feature hidden deep inside. You have to know to dig it out.

Project for Current Year

It’s called the What-If Worksheet. After you’re done with your previous year’s taxes, you use the What-If Worksheet to project your taxes for the current year. It also makes it easy to compare different scenarios.

The idea of the What-If Worksheet is that you can create alternative scenarios and see how your taxes will change.


What if you earn more income?


What if your income drops?


What if you take on a mortgage?


What if you sell some investments and realize capital gains?


What if you convert some IRA money to Roth AND you sell some investments with a capital loss?


The What-If Worksheet is only available in TurboTax downloaded software, not in its online software. It’s another reason to use TurboTax downloaded software, not the online software. As far as I know, only TurboTax has it. H&R Block doesn’t have it. Neither does FreeTaxUSA.

Plan for Roth Conversion

I’ll use the same example I used in the previous post Roth Conversion with Social Security and Medicare IRMAA to show how you can plan for Roth conversion with this Work-If Worksheet in TurboTax.

A retired couple, both age 66, Florida residents, married filing jointly with no dependents. They live on $60,000 of Social Security benefits, $20,000 of Traditional IRA withdrawals, $5,000 of interest income, and $10,000 of qualified dividends. They have no other income or deductions. Both of them enrolled in Medicare Part B and Part D.

TurboTax shows that this couple with $95,000 of income paid $2,018 in federal income tax. That’s only 2% of their income. They are interested in doing a Roth conversion next year to take advantage of their low tax rate.

Find What-If Worksheet

You’ll have to know that the What-If Worksheet exists and really look for it.

Click on Forms on the top right in TurboTax downloaded software and then click on the Open Form button.

This opens a pop-up window. Type “what” or “what-if” in the search box. Double-click on the “What-If Worksheet” in the search results to open it.

Create a Baseline

The What-If Worksheet has four columns. Column 1 is auto-populated with data from your tax return. Columns 2 to 4 are used for tax planning.

First, you create a baseline for the current year. Checking the box “Copy column 1 to column 2” under “Copy columns” copies your tax return for last year to Column 2. Checking the box “Check box to use XXXX tax rates” under Column 2 applies the current year’s tax brackets. You can give it a short name such as “Baseline.”

Change the numbers under Column 2 with what you already know will be different this year. For example, you know you will earn more interest because interest rates have gone up, you know you will have less in dividends because you sold some investments last year, your Social Security benefits will go up because of COLA, etc.

Column 2 is your best guess of your current year’s taxes before you take any deliberate actions.

Test Alternatives

After you create a good baseline for the current year, suppose you want to see how converting $20,000 from your Traditional IRA to Roth will affect your taxes.

Copy Column 2 to Column 3 by checking the box under “Copy columns.” Check the box to use the current year’s tax brackets again. Give it a short description such as “Convert $20k.”

Scroll down to the line for taxable IRA distribution and raise the number by $20,000 from the baseline in Column 2 to your alternative scenario in Column 3.

The What-If Worksheet shows this additional income will increase the taxable amount of the Social Security benefits for this couple in the example by $17,000. Together with the $20,000 Roth conversion, the AGI will increase by $37,000.

Scroll down further. The What-If Worksheet shows that converting $20,000 to Roth will increase the total tax from $2,138 in the baseline to $6,565. That’s a difference of $4,427, which translates into $4,427 / $20,000 = 22% average marginal tax rate on converting $20k.

Now you can decide whether paying a 22% tax to convert $20,000 is worth it. Do it if you think your future tax rate will be higher than 22%. Don’t do it if you think your future tax rate will be lower than 22%.

If you’d like to test another alternative, such as converting $50k, repeat the above to copy the baseline in Column 2 to Column 4 and increase the IRA withdrawal by $50k in Column 4. Calculate the difference in total tax and the average marginal tax rate when you convert $50k.

Case Study Spreadsheet

The Case Study Spreadsheet in the previous post shows the same effect for converting $20k in this same example.

The chart from the Case Study Spreadsheet shows that increasing the IRA withdrawal from $20k to $40k produces a 22% marginal tax rate. It also shows that this same marginal tax rate continues before hitting a spike when the IRA withdrawal reaches $45k (converting $25k to Roth on top of a $20k withdrawal).

The What-If Worksheet in TurboTax doesn’t show the marginal tax rate directly. You have to calculate it yourself by dividing the difference in total tax by the conversion amount. Nor does it show the marginal tax rate for different conversion amounts in a chart. You don’t know where it may hit a spike. You’d have to do trial-and-error with different inputs: $20k is OK, what about $30k; $50k is too high, what about $40k, …

It also only shows the difference in federal income tax. It doesn’t include the effect on state income tax or Medicare IRMAA. The Case Study Worksheet includes both the state income tax and Medicare IRMAA.

The What-If Worksheet in TurboTax is easier to use though. TurboTax already has your tax data. You don’t have to find the right places to enter them in a spreadsheet. You don’t need to learn how to use a spreadsheet if that sounds intimidating.

Professional Software

I heard great praises for a professional tax planning software called Holistiplan. Many financial advisors use it to do tax planning for their clients. I watched a demo of Holistiplan on YouTube:

Holistiplan Demo

Holistiplan uses the same technique as the What-If Worksheet in TurboTax.

Copy data from the tax return for the previous year to the current year. Make known changes to create a baseline. Copy the baseline to an alternative scenario. Make changes to the alternative scenario and compare it with the baseline.

It also produces a chart of the marginal tax rate similar to the Case Study Spreadsheet.

If you go to a financial advisor this type of planning, it may cost you $1,000 or more. After you use TurboTax downloaded software to file your taxes, you already have the What-If Worksheet in TurboTax for tax planning estimates. It doesn’t show a chart or include the effect on state tax or Medicare IRMAA but it gets you 80% there. Use the Case Study Spreadsheet if you want 100%.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on May 15, 2023 04:58

May 8, 2023

Two Fundamental Drivers of Financial Success in Retirement

Despite a long list of things that Fidelity’s retirement planning tool doesn’t do, I still use it as a high-level model. The planning exercise I did at the end of last year revealed two fundamental drivers of financial success in retirement.

Baseline Spending

First, I created a baseline annual spending. The planning tool showed a table of the projected values of our investments at different ages when the investment returns are “significantly below average.” Significantly below average means “a scenario in which your outcome was successful 90% of the time” using historical data. I created this chart by sampling a few age milestones from the table:

All values are in today’s dollars. I’m not showing numbers on the vertical axis for obvious reasons.

Our investment portfolio is projected to increase while we take withdrawals to support the planned annual spending. That’s both good and bad. It’s good because it shows we have enough for our retirement. It’s bad because we don’t need or want 60% more money at age 95 than at age 65.

Higher Spending

Next, I increased the annual spending by 20%. The planning tool showed a different set of projected values:

Now the projected values go down with age. It gets dangerously close to zero at age 95. This means that our sustainable spending is somewhere between these two levels. If the future market returns are below 90% of returns in the past, we can still spend a little more than the baseline plan but not 20% more.

Better Market Conditions

The planning tool also produced a table of projected values for returns merely below average but not significantly below average. Below average means “a scenario in which your outcome was successful 75% of the time” as opposed to 90%. The projected asset values under these better market conditions while supporting the higher spending looks like the blue line in this chart:

It shows that if the returns are only below average — not significantly below average — our assets would be higher than the baseline scenario through age 90 while supporting 20% higher spending every year.

Fundamental Drivers

When I presented these three scenarios to my wife, she pointed out that it was only too obvious.

“You didn’t have to run a fancy tool to tell me that higher spending will drain our investments faster and better returns will help.”

She told me the same thing when I said I discovered the secrets to a fat 401k 11 years ago.

It’s obvious because it’s true. Spending and investment returns are indeed the two fundamental drivers of financial success in retirement because they compound. We can handle low returns (the green line) or higher spending (the blue line) but not both year after year if we live long (the red line).

When we think of the usual consternations in retirement planning — when to claim Social Security, which accounts to withdraw from first, when and how much to convert to Roth, buckets strategy or proportional withdrawals, buy an annuity or not, … — everything added together can’t alter our retirement trajectory as much as our annual spending and investment returns.

If we’re on the red line because our annual spending is too high relative to the investment returns, the most optimal tactics in Social Security claiming, Roth conversion, and withdrawal sequencing won’t yank us back to the green line. We’ll need to reduce spending. If we’re on the blue line because we aren’t so unlucky with investment returns, we’ll do just fine even if we aren’t so clever in retirement planning tactics.

You don’t have to use Fidelity’s retirement planning tool to see this effect. Any other tool will show the same two fundamental drivers.

Make It Robust

Retirement planning tactics are useful but we should make our plan NOT rely on them. If optimal executions of Social Security claiming, Roth conversion, and withdrawal sequencing make or break our retirement, it means our plan is too fragile. It isn’t robust enough when a slip in execution, a miscalculation, or a change of laws will knock us off track.

The goal should be to make our retirement successful regardless. When we get our spending right for the market conditions, any optimization tactics will only be icing on the cake, and suboptimal executions won’t jeopardize our retirement. If we get our spending wrong for the market conditions, no amount of optimization will rescue our retirement.

***

We’ll be watching the trajectory of our investments. If we see we’re at risk of going on the red line when we have a combination of high spending and low returns, we’ll reduce spending and try to move toward the green line. If we see that the market returns aren’t too bad, we’ll know we have more leeway in our spending. That’s how we’ll keep our eyes on the two fundamental drivers of financial success in retirement.

I told my wife that’s all she needs to do if something happens to me. Everything else is optional. How does SECURE Act 2.0 alter the financial success of our retirement? It does not, because it doesn’t change the two fundamental drivers.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on May 08, 2023 06:27

April 30, 2023

Cash Out Old I Bonds to Buy New Ones for a Better Rate

TreasuryDirect announced that I Bonds bought between May and October 2023 will have a 0.9% fixed rate plus a variable rate that changes every six months. This new fixed rate is the highest we’ve ever seen in 15 years.

Table of ContentsLow Fixed Rate on Older I BondsEarly Withdrawal PenaltyNew 12-Month Holding PeriodPay Tax on Accrued InterestAnnual Purchase LimitLow Fixed Rate on Older I Bonds

If you bought I Bonds between May 2020 and October 2022, the fixed rate on those older I Bonds is 0%. This 0% fixed rate stays with the bonds for their entire life up to 30 years. If you cash out the older I Bonds to buy new ones, you will benefit from the higher fixed rate over the long run.

I Bonds bought between November 2022 and April 2023 are still in the 12-month mandatory holding period by October 2023. They can’t be switched to new bonds until their mandatory holding period is over.

You see a list of your existing I Bonds by clicking on Current Holdings after you log in to your TreasuryDirect account. Then you choose Series I Savings Bond and click on Submit.

Here’s a reminder of the fixed rate on existing I Bonds issued since November 2010:

Issue MonthFixed Rate11/2022 – 04/20230.4%05/2020 – 10/20220.0%11/2019 – 04/20200.2%11/2018 – 10/20190.5%05/2018 – 10/20180.3%11/2017 – 04/20180.1%11/2016 – 10/20170.0%11/2015 – 10/20160.1%11/2014 – 10/20150.0%05/2014 – 10/20140.1%11/2013 – 04/20140.2%11/2010 – 10/20130.0%I Bonds Fixed Rate

Look up the fixed rate for your existing I Bonds from the table above. If the fixed rate is 0%, 0.1%, 0.2%, or 0.3%, they’re all good candidates for switching to new ones.

Early Withdrawal Penalty

You’ll pay an early withdrawal penalty when you cash out I Bonds within five years but you can minimize the penalty if you time it correctly.

The early withdrawal penalty is the interest earned in the last three months before you cash out the bond. The variable rate will drop to a relatively low 3.38% annual rate in the coming months. If you wait three months after the bonds start earning 3.38%, you only give up three months’ worth of interest at 3.38% per year, which comes out to about 0.85%. You’ll make up for it in about a year from a higher fixed rate when you hold the new I Bonds for the long term.

I Bonds issued in the following months can be cashed out on these dates to keep the penalty low:

Issue MonthAfter 3 months at 3.38% Variable RateJanuary or July10/1/2023May or November8/1/2023June or December9/1/2023

It’s a little tricky for I Bonds issued in these other months:

Issue MonthAfter 3 months at 3.38% Variable RateFebruary or August11/1/2023March or September12/1/2023April or October1/1/2024

The 3-month period at the 3.38% annual rate doesn’t end until after November 1, 2023, but we don’t know whether the fixed rate will drop by that time. If the fixed rate doesn’t drop, you can cash out on the dates in the table above and get new I Bonds. If you worry that the fixed rate might drop after November 1, 2023, cashing out in October 2023 to get new I Bonds will give up a part of the interest at the 6.48% annual rate as opposed to 3.38%.

If you have spare cash, you can buy new I Bonds first in October and wait a few months to cash out your older I Bonds on the dates in the table above. This way you keep the early withdrawal penalty low while locking in the 0.9% fixed rate in case the fixed rate drops after November 1, 2023.

Take a look at the issue month of your older I Bonds. Set a calendar reminder to cash them out on the corresponding dates.

New 12-Month Holding Period

The new I Bonds you buy will have a new 12-month holding period. It’s not a problem when you hold them for the long term.

If there’s a chance that you’ll need the money from I Bonds in 12 months, don’t switch. You won’t make up for the early withdrawal penalty anyway if you hold the new bonds only for another year.

Pay Tax on Accrued Interest

You will pay federal income tax on the interest earned when you cash out I Bonds unless you chose to pay tax annually. See I Bonds Tax Treatment During Your Lifetime and After You Die.

The interest is exempt from state and local taxes. The 3-month early withdrawal penalty doesn’t count as interest earned because you never received it. You won’t pay tax on the early withdrawal penalty.

TreasuryDirect won’t withhold taxes when you cash out I Bonds. You will add the interest to your tax return using the 1099 form from TreasuryDirect.

Remember to download or print the 1099 form from TreasuryDirect in January. It’s under ManageDirect -> Manage My Taxes.

TreasuryDirect sends an email notification when the 1099 form is available but they won’t send the form by mail. Set a calendar reminder for yourself to download the 1099 form on January 31 in case you miss the email notification or the email notification is mistakenly directed to the spam folder.

Annual Purchase Limit

Buying new I Bonds after cashing out older I Bonds still counts toward your annual purchase limit. If you already bought I Bonds in 2023 or if you have more than $10,000 worth of I Bonds at 0%, you can’t switch all of them to new ones by buying new bonds directly but you can still buy them as gifts and hold them for delivery in the future.

Buying I Bonds doesn’t count toward the annual limit of the purchaser. It counts toward the annual limit of the recipient in the year when the gift is delivered to the recipient.

This works especially well for married couples. You can cash out all your old 0% fixed rate I Bonds, buy new ones as gifts to your spouse, and hold the gifts for delivery in the future. The new bonds start earning the 0.9% fixed rate right away while they’re being held in the gift box. Then you deliver the gifts in $10,000 chunks to your spouse in the coming years. Your spouse can do the same in the opposite direction.

See Buy I Bonds as a Gift: What Works and What Doesn’t and Deliver I Bonds Bought as a Gift in TreasuryDirect for more details on how this works.

***

The 15-year high fixed rate represents a great opportunity to lock into a higher fixed rate for many years to come. If you plan to hold I Bonds for the long term, see which bonds you should switch over, when is the best time to cash out, and whether you should buy new bonds directly or via gifts.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on April 30, 2023 11:53

April 21, 2023

Which Schwab Money Market Fund Is the Best at Your Tax Rates

After reading my previous posts Which Vanguard Money Market Fund Is the Best at Your Tax Rates and Which Fidelity Money Market Fund Is the Best at Your Tax Rates, a reader asked me to do the same for Charles Schwab. Many people have a brokerage account with Schwab. It’s more convenient to keep cash and other investments in one place. Although Vanguard charges the lowest fees on its money market funds, if you don’t need absolutely the highest yield, a Schwab money market fund is still quite good enough.

As I wrote in No FDIC Insurance – Why a Brokerage Account Is Safe, when you keep your cash in a money market fund at a broker, the safety of your money doesn’t depend on the financial health of the broker. The safety comes directly from the safety of the holdings in the money market fund. Your money market fund is safe when the fund’s underlying holdings are safe.

Table of ContentsWhy Money Market FundTaxable Money Market FundsPrime Money Market FundsGovernment Money Market FundsSingle State Tax-Exempt Money Market FundsNational Tax-Exempt Money Market FundTaxable or Tax-Exempt?Yield SwingsMM OptimizerYour Tax RatesCompare After-Tax YieldWhy Money Market Fund

The reason to keep your cash in a money market fund, as opposed to a high yield savings account, is that you’re not depending on any bank to set their rate competitively. You automatically get the market yield minus the fund manager’s cut, no more, no less, sort of like when you invest in an index fund. You’re not moving to another bank because it’s offering a promotional rate. You’re not moving again when that bank decides to lag behind. See my Guide to Money Market Funds & High Yield Savings Accounts.

Schwab offers eight money market funds of different types. Each fund has an Investor Shares class and an Ultra Shares class. Ultra Shares pay more but they require a $1,000,000 minimum. Investor Shares require no minimum. I will only talk about Investor Shares in this post.

These eight money market funds differ in their underlying holdings and tax treatment at both the federal and the state levels. Which one is slightly better for you than another depends on your preference for convenience and your federal and state tax brackets.

Taxable Money Market Funds

Four of the eight Schwab money market funds are taxable money market funds. You pay federal income tax on the income earned from these funds. A portion of the income earned in some funds is exempt from state income tax in most states.

The quoted yield on any money market fund is always a net yield after the expense ratio is already deducted. You don’t need to deduct it again.

Unlike Vanguard and Fidelity, Charles Schwab doesn’t sweep uninvested cash to a money market fund (except in some legacy accounts). The default “cash sweep” pays much less than a money market fund. You have to buy a money market fund yourself if you want to earn more on your cash. Charles Schwab doesn’t automatically liquidate from a money market fund to cover trades or transfers either. You have to sell a money market fund manually.

Prime Money Market Funds

Schwab Value Advantage Money Fund (SWVXX) is a prime money market fund. It invests in repurchase agreements, CDs, time deposits, and commercial paper. Prime money market funds pay more but they have a slightly higher risk.

The income earned from a prime money fund is fully taxable at the federal level. A small percentage of the income may be exempt from state income tax. That percentage varies from year to year. It was 0% in 2022.

Government Money Market Funds

Schwab Government Money Fund (SNVXX), Schwab Treasury Obligations Money Fund (SNOXX), and Schwab U.S. Treasury Money Fund (SNSXX) are government money market funds. They only invest in government securities and repurchase agreements that are collateralized by cash or government securities.

Think of repurchase agreements (“repo”) as a deal with a pawn shop. Entities give collaterals to the money market fund for short-term cash. They’ll come back later to buy back (“repurchase”) their collaterals at a higher price. If they don’t fulfill the repurchase agreement, the money market fund will sell those collaterals. Repurchase agreements aren’t guaranteed by the government. Their safety comes from the collaterals.

A government money market fund is safer than a prime money market fund. Schwab U.S. Treasury Money Fund (SNSXX) is the safest of the three because it invests only in Treasuries. It pays a little less though.

The income earned from these three funds is fully taxable at the federal level. A percentage of the income is exempt from state income tax. That percentage varies from year to year.

State Tax Exemption in 2022Schwab Government Money Fund (SNVXX)24% (0% in CA, NY, CT)Schwab Treasury Obligations Money Fund (SNOXX)19% (0% in CA, NY, CT)Schwab U.S. Treasury Money Fund (SNSXX)100%

The expense ratio is the same across all four taxable money market funds. If you want a higher yield and you’re not concerned about the slightly higher risk, you can go with the prime money market fund (SWVXX). If you want the most solid peace of mind at the cost of a slightly lower yield, you can choose the U.S. Treasury fund (SNSXX) for extra safety and additional state income tax savings.

The other two funds — Schwab Government Money Fund (SNVXX) and Schwab Treasury Obligations Money Fund (SNOXX) — are good middle ground with safer holdings than the prime fund and you’re not giving up too much yield. Schwab Treasury Obligations Money Fund (SNOXX) limits the repurchase agreements to being backed by Treasuries only. Schwab Government Money Fund (SNVXX) includes repurchase agreements backed by both Treasuries and government agency debts.

Remember to claim the state tax exemption when you do your taxes. See how to do it in State Tax-Exempt Treasury Interest from Mutual Funds and ETFs.

Single State Tax-Exempt Money Market Funds

Schwab offers tax-exempt money market funds specifically for investors in higher tax brackets in California and New York. Schwab California Municipal Money Fund (SWKXX) and Schwab New York Municipal Money Fund (SWYXX) invest in high-quality, short-term municipal securities issued by entities within the state. Income from these funds is tax-exempt from both the federal income tax and the state income tax. They’re sometimes called “double tax-free” funds.

The yield on these single state tax-exempt money market funds is lower than the yield on the four taxable money market funds but the federal and state tax exemption makes up for it when you’re in a high tax bracket.

Remember to claim the state tax exemption when you do your taxes. See how to do it in State Tax-Exempt Muni Bond Interest from Mutual Funds and ETFs.

National Tax-Exempt Money Market Fund

Schwab offers two tax-exempt money market funds for investors in higher tax brackets outside of California and New York. Schwab Municipal Money Fund (SWTXX) and Schwab AMT Tax-Free Money Fund (SWWXX) are more diversified than the two single-state funds because they invest in short-term, high-quality municipal securities from many states. The two funds are similar. AMT tax-free or not makes a difference when you’re subject to the Alternative Minimum Tax but a lot fewer people are affected by it now than before.

Income from these two national tax-exempt money market funds is tax-exempt from the federal income tax but only a small percentage is exempt from state income tax. The yield is lower than the yield on the four taxable money market funds but the federal income tax exemption makes up for it when you’re in a high tax bracket. If you live in California or New York, you can still invest in these national funds if you don’t mind paying more in state income tax.

Remember to claim the small state tax exemption when you do your taxes. See how to do it in State Tax-Exempt Muni Bond Interest from Mutual Funds and ETFs.

Taxable or Tax-Exempt?

A tax-exempt money market fund offers tax savings but it pays less. Choose a tax-exempt fund if you’re in a high tax bracket. Choose a taxable fund if you’re in a low tax bracket. If you’re not sure whether your federal and state tax brackets are considered high or low, you can use a calculator to see which fund offers a better yield after taxes.

Yield Swings

A wrinkle in comparing taxable and tax-exempt money market funds is that the yield on tax-exempt money market funds swings wildly throughout the year. This chart shows the yield on a taxable money market fund and the yield on a tax-exempt money market fund over a 12-month period:

While the yield on the taxable fund (green line) rose steadily over time as the Fed raised interest rates, the yield on the tax-exempt fund (orange line) swung wildly up and down. If you happen to compare the after-tax yields when the yield on the tax-exempt fund is near a top, it would show that the tax-exempt fund is better even in a low tax bracket. If you happen to compare them when the yield on the tax-exempt fund is near a bottom, it would show that the taxable fund is better even in a high tax bracket.

MM Optimizer

So you can’t just adjust for taxes only based on the yields at this moment. You need to look over a longer period to take into account the wild swings in the yield on tax-exempt funds.

User retiringwhen on the Bogleheads forum created a Google Sheet that does this. It’s called MM Optimizer. Although this tool only backtests Vanguard money market funds, it’s also informative when you use a Schwab money market fund. If the tool shows that a Vanguard taxable money market fund is better than a Vanguard tax-exempt fund at your tax rates, it’s highly likely that a Schwab taxable money market fund is also better than a Schwab tax-exempt fund for you at the same tax rates.

Your Tax Rates

MM Optimizer is a shared as View Only. After you make a copy of it to your Google account, you change the tax rates on the My Parameters tab to your tax rates.

My Parameters tabCompare After-Tax Yield

The My Charts tab shows the after-tax yield of different funds over the last 12 months. You can watch the yields and switch back and forth between a taxable fund and a tax-exempt fund but I wouldn’t bother. The chart shows how many times you would’ve had to switch to catch the temporary swings and how short-lived each switch was.

My Charts tab

I would take a look at this chart and see which line is on top most of the time. Choose a Schwab taxable money market fund and stay with it if the chart shows that the smoother line is on top most of the time. Choose a Schwab tax-exempt money market fund if the chart shows that the bouncy line is on top most of the time.

When I played with MM Optimizer, it showed that a taxable money market fund was still better for someone in a 35.8% federal income tax bracket (32% plus 3.8% Net Investment Income Tax) and a 9% state income tax bracket. The tax brackets must be higher than those levels for a tax-exempt money market fund to win.

MM Optimizer has a lot more features but you don’t have to get into those. It’s simple to use if you only look at the places I’m showing here. The author is still adding new features. You’ll find the link to the latest version in this post on the Bogleheads forum.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on April 21, 2023 14:22

April 12, 2023

2023 2024 HSA Contribution Limits and HDHP Qualification

The contribution limits for various tax-advantaged accounts for the following year are usually announced in October, except for the HSA, which come out in April or May. The contribution limits are adjusted for inflation each year, subject to rounding rules.

Table of ContentsHSA Contribution LimitsAge 55 Catch-Up ContributionTwo Plans Or Mid-Year ChangesHDHP QualificationContribute Outside PayrollBest HSA ProvidersHSA Contribution Limits202220232024Individual Coverage$3,650$3,850$4,150Family Coverage$7,300$7,750$8,300HSA Contribution Limits

Source: IRS Rev. Proc. 2021-25, Rev. Proc. 2022-24, Rev. Proc. 2023-23.

Employer contributions are included in these limits.

The family coverage numbers happened to be double the individual coverage numbers in 2022 and 2024 but it isn’t always the case. Because the individual coverage limit and the family coverage limit are both rounded to the nearest $50, the family coverage limit can be slightly more or slightly less than double the individual coverage limit when one number rounds up and the other number rounds down.

Age 55 Catch-Up Contribution

As in 401k and IRA contributions, you are allowed to contribute extra if you are above a certain age. If you are age 55 or older by the end of the year (not age 50 as in 401k and IRA contributions), you can contribute an additional $1,000 to your HSA. If you are married, and both of you are age 55, each of you can contribute an additional $1,000 to your respective HSA.

However, because HSA is in one individual’s name, just like an IRA — there is no joint HSA even when you have family coverage — only the person age 55 or older can contribute the additional $1,000 in his or her own name. If only the husband is 55 or older and the wife contributes the full family contribution limit to the HSA in her name, the husband has to open a separate account in his name for the additional $1,000. If both husband and wife are age 55 or older, they must have two HSA accounts in separate names if they want to contribute the maximum. There’s no way to hit the combined maximum with only one account.

The $1,000 additional contribution limit is fixed by law. It’s not adjusted for inflation.

Two Plans Or Mid-Year Changes

The limits are more complicated if you are married and the two of you are on different health plans. It’s also more complicated when your health insurance changes mid-year. The insurance change could be due to a job change, marriage or divorce, enrolling in Medicare, the birth of a child, and so on.

For those situations, please read HSA Contribution Limit For Two Plans Or Mid-Year Changes.

HDHP Qualification

You can only contribute to an HSA if you have a High Deductible Health Plan (HDHP). You can use the money already in the HSA for qualified medical expenses regardless of what insurance you currently have.

The IRS also defines what qualifies as an HDHP. For 2023, an HDHP with individual coverage must have at least $1,500 in annual deductible and no more than $7,500 in annual out-of-pocket expenses. For family coverage, the numbers are a minimum of $3,000 in annual deductible and no more than $15,000 in annual out-of-pocket expenses.

For 2024, an HDHP with individual coverage must have at least $1,600 in annual deductible and no more than $8,050 in annual out-of-pocket expenses. For family coverage, the numbers are a minimum of $3,200 in annual deductible and no more than $16,100 in annual out-of-pocket expenses.

Please note the deductible number is a minimum while the out-of-pocket number is a maximum. If the out-of-pocket limit of your insurance policy is too high, it doesn’t qualify as an HSA-eligible policy.

In addition, just having the minimum deductible and the maximum out-of-pocket isn’t sufficient to make a plan qualify as HSA eligible. The plan must also meet other criteria. See Not All High Deductible Plans Are HSA Eligible.

202220232024Individual Coveragemin. deductible$1,400$1,500$1,600max. out-of-pocket$7,050$7,500$8,050Family Coveragemin. deductible$2,800$3,000$3,200max. out-of-pocket$14,100$15,000$16,100HDHP Qualification

Source: IRS Rev. Proc. 2021-25, Rev. Proc. 2022-24, Rev. Proc. 2023-23.

Contribute Outside Payroll

If you have a High Deductible Health Plan (HDHP) through your employer, your employer may already set up a linked HSA for you at a selected provider. Your employer may be contributing an amount on your behalf there. Your payroll contributions also go into that account. Your employer may be paying the fees for you on that HSA. You save Social Security and Medicare taxes when you contribute to the HSA through payroll.

When you contribute to an HSA outside an employer, you get the tax deduction on your tax return, similar to when you contribute to a Traditional IRA. If you use tax software, be sure the answer the questions on HSA contributions. The tax deduction shows up on Form 8889 line 13 and Schedule 1 line 13.

If your HDHP also covers your adult children who are not claimed as a dependent on your tax return, they can also contribute to an HSA in their own name if they don’t have other non-HDHP coverage. They get a separate family coverage limit. They will have to open an HSA on their own with an HSA provider.

Best HSA Providers

If you get the HSA-eligible high deductible plan through an employer, your employer usually has a designated HSA provider for contributing via payroll deduction. It’s best to use that one because your contributions via payroll deduction are usually exempt from Social Security and Medicare taxes. If you want better investment options, you can transfer or roll over the HSA money from your employer’s designated provider to a provider of your choice afterward. See How To Rollover an HSA On Your Own and Avoid Trustee Transfer Fee.

If you are not going through an employer, or if you’d like to contribute on your own, you can also open an HSA with a provider of your choice. For the best HSA providers with low fees and good investment options, see Best HSA Provider for Investing HSA Money.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on April 12, 2023 05:35

2022 2023 2024 HSA Contribution Limits and HDHP Qualification

The contribution limits for various tax-advantaged accounts for the following year are usually announced in October, except for the HSA, which come out in April or May. The contribution limits are adjusted for inflation each year, subject to rounding rules.

Table of ContentsHSA Contribution LimitsAge 55 Catch-Up ContributionTwo Plans Or Mid-Year ChangesHDHP QualificationContribute Outside PayrollBest HSA ProvidersHSA Contribution Limits202220232024Individual Coverage$3,650$3,850$4,150Family Coverage$7,300$7,750$8,300HSA Contribution Limits

Source: IRS Rev. Proc. 2021-25, Rev. Proc. 2022-24, author’s calculation.

Employer contributions are included in these limits.

The family coverage numbers happened to be double the individual coverage numbers in 2022 and 2024 but it isn’t always the case. Because the individual coverage limit and the family coverage limit are both rounded to the nearest $50, the family coverage limit can be slightly more or slightly less than double the individual coverage limit when one number rounds up and the other number rounds down.

Age 55 Catch-Up Contribution

As in 401k and IRA contributions, you are allowed to contribute extra if you are above a certain age. If you are age 55 or older by the end of the year (not age 50 as in 401k and IRA contributions), you can contribute an additional $1,000 to your HSA. If you are married, and both of you are age 55, each of you can contribute an additional $1,000 to your respective HSA.

However, because HSA is in one individual’s name, just like an IRA — there is no joint HSA even when you have family coverage — only the person age 55 or older can contribute the additional $1,000 in his or her own name. If only the husband is 55 or older and the wife contributes the full family contribution limit to the HSA in her name, the husband has to open a separate account in his name for the additional $1,000. If both husband and wife are age 55 or older, they must have two HSA accounts in separate names if they want to contribute the maximum. There’s no way to hit the combined maximum with only one account.

The $1,000 additional contribution limit is fixed by law. It’s not adjusted for inflation.

Two Plans Or Mid-Year Changes

The limits are more complicated if you are married and the two of you are on different health plans. It’s also more complicated when your health insurance changes mid-year. The insurance change could be due to a job change, marriage or divorce, enrolling in Medicare, the birth of a child, and so on.

For those situations, please read HSA Contribution Limit For Two Plans Or Mid-Year Changes.

HDHP Qualification

You can only contribute to an HSA if you have a High Deductible Health Plan (HDHP). You can use the money already in the HSA for qualified medical expenses regardless of what insurance you currently have.

The IRS also defines what qualifies as an HDHP. For 2023, an HDHP with individual coverage must have at least $1,500 in annual deductible and no more than $7,500 in annual out-of-pocket expenses. For family coverage, the numbers are a minimum of $3,000 in annual deductible and no more than $15,000 in annual out-of-pocket expenses.

For 2024, an HDHP with individual coverage must have at least $1,600 in annual deductible and no more than $8,050 in annual out-of-pocket expenses. For family coverage, the numbers are a minimum of $3,200 in annual deductible and no more than $16,100 in annual out-of-pocket expenses.

Please note the deductible number is a minimum while the out-of-pocket number is a maximum. If the out-of-pocket limit of your insurance policy is too high, it doesn’t qualify as an HSA-eligible policy.

In addition, just having the minimum deductible and the maximum out-of-pocket isn’t sufficient to make a plan qualify as HSA eligible. The plan must also meet other criteria. See Not All High Deductible Plans Are HSA Eligible.

202220232024Individual Coveragemin. deductible$1,400$1,500$1,600max. out-of-pocket$7,050$7,500$8,050Family Coveragemin. deductible$2,800$3,000$3,200max. out-of-pocket$14,100$15,000$16,100HDHP Qualification

Source: IRS Rev. Proc. 2021-25, Rev. Proc. 2022-24, author’s calculation.

Contribute Outside Payroll

If you have a High Deductible Health Plan (HDHP) through your employer, your employer may already set up a linked HSA for you at a selected provider. Your employer may be contributing an amount on your behalf there. Your payroll contributions also go into that account. Your employer may be paying the fees for you on that HSA. You save Social Security and Medicare taxes when you contribute to the HSA through payroll.

When you contribute to an HSA outside an employer, you get the tax deduction on your tax return, similar to when you contribute to a Traditional IRA. If you use tax software, be sure the answer the questions on HSA contributions. The tax deduction shows up on Form 8889 line 13 and Schedule 1 line 13.

If your HDHP also covers your adult children who are not claimed as a dependent on your tax return, they can also contribute to an HSA in their own name if they don’t have other non-HDHP coverage. They get a separate family coverage limit. They will have to open an HSA on their own with an HSA provider.

Best HSA Providers

If you get the HSA-eligible high deductible plan through an employer, your employer usually has a designated HSA provider for contributing via payroll deduction. It’s best to use that one because your contributions via payroll deduction are usually exempt from Social Security and Medicare taxes. If you want better investment options, you can transfer or roll over the HSA money from your employer’s designated provider to a provider of your choice afterward. See How To Rollover an HSA On Your Own and Avoid Trustee Transfer Fee.

If you are not going through an employer, or if you’d like to contribute on your own, you can also open an HSA with a provider of your choice. For the best HSA providers with low fees and good investment options, see Best HSA Provider for Investing HSA Money.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on April 12, 2023 05:35

April 11, 2023

Which Fidelity Money Market Fund Is the Best at Your Tax Rates

The previous post Which Vanguard Money Market Fund Is the Best at Your Tax Rates covered Vanguard money market funds. Vanguard has the best money market funds because they charge the lowest fees in their funds. However, many people — myself included — have a brokerage account at Fidelity Investments. It’s more convenient to keep cash and other investments in one place. If you don’t need absolutely the highest yield, a Fidelity money market fund is still quite good enough.

As I wrote in No FDIC Insurance – Why a Brokerage Account Is Safe, when you keep your cash in a money market fund at a broker, the safety of your money doesn’t depend on the financial health of the broker. The safety comes directly from the safety of the holdings in the money market fund. Your money market fund is safe when the fund’s underlying holdings are safe.

Table of ContentsWhy Money Market FundTaxable Money Market FundsCore-Eligible Money Market FundsPrime Money Market FundsGovernment Money Market FundsSingle State Tax-Exempt Money Market FundsNational Tax-Exempt Money Market FundTaxable or Tax-Exempt?Yield SwingsMM OptimizerYour Tax RatesCompare After-Tax YieldWhy Money Market Fund

The reason to keep your cash in a money market fund, as opposed to a high yield savings account, is that you’re not depending on any bank to set their rate competitively. You automatically get the market yield minus the fund manager’s cut, no more, no less, sort of like when you invest in an index fund. You’re not moving to another bank because it’s offering a promotional rate. You’re not moving again when that bank decides to lag behind. See my Guide to Money Market Funds & High Yield Savings Accounts.

Fidelity offers at least 18 money market funds of different types. That’s not counting Institutional funds and funds that are only available in certain account types. These 18 money market funds differ in their underlying holdings and tax treatment at both the federal and the state levels. Which one is slightly better for you than another depends on your preference for convenience and your federal and state tax brackets.

Taxable Money Market Funds

Seven of the 18 Fidelity money market funds are taxable money market funds. You pay federal income tax on the income earned from these funds. A portion of the income earned in some funds is exempt from state income tax in most states.

The quoted yield on any money market fund is always a net yield after the expense ratio is already deducted. You don’t need to deduct it again.

Core-Eligible Money Market Funds

Every Fidelity brokerage account has a core position. You don’t have to do anything extra to buy or sell the core position. Any cash you transfer into your Fidelity brokerage account will automatically land in the core position. Any cash you transfer out of your Fidelity brokerage account will come out of the core position.

Your choices in the core position may include these money market funds depending on the account type:

FundExpense Ratio2022 State Tax ExemptionFidelity Government Cash Reserves (FDRXX)0.34%29% (0% in CA, CT, NY)Fidelity Government Money Market Fund (SPAXX)0.42%31% (0% in CA, CT, NY)Fidelity Treasury Money Market Fund (FZFXX)0.42%30% (0% in CA, CT, NY)

The income earned in these funds is fully taxable at the federal level. A percentage of the income is exempt from state income tax. That percentage varies from year to year.

There isn’t much difference among these three core-eligible funds. If Fidelity Government Cash Reserves (FDRXX) is an option, I would choose that one as the core position because it has a lower expense ratio.

If you’d like to see what options you have as your core position, click on your core position marked with two asterisks on the Positions page and then click on the Change Core Position button. If you see FCASH as an option in your account, don’t choose that one because FCASH isn’t a money market fund.

All money market funds except the core position require a buy order to get money into them but you don’t have to sell manually. If your core position isn’t sufficient for a debit, Fidelity will automatically sell from your money market fund to cover the difference.

Fidelity Cash Management Account only uses bank sweep as the core position. You can’t change it but you can still buy a money market fund manually in a Cash Management Account.

Prime Money Market Funds

Fidelity Money Market Fund (SPRXX) and Fidelity Money Market Fund Premium Class (FZDXX) are prime money market funds. They invest in repurchase agreements, CDs, and commercial paper. Prime money market funds pay more but they have a slightly higher risk.

The Premium Class fund (FZDXX) requires a $100,000 minimum investment in a taxable account and a $10,000 minimum investment in an IRA. The minimum is only required to get started. You can drop below the minimum after you have the fund. The regular class fund (SPRXX) doesn’t require a minimum investment but it pays less than the Premium Class fund because it has a higher expense ratio (0.42% versus 0.36%).

The income earned from these prime money funds is fully taxable at the federal level. A small percentage of the income is exempt from state income tax. That percentage varies from year to year. It was 0% in 2022 and 4% in 2021 (0% in CA, CT, and NY).

Government Money Market Funds

Fidelity Government Money Market Fund Premium Class (FZCXX) and Fidelity Treasury Only Money Market Fund (FDLXX) are government money market funds. They only invest in government securities and repurchase agreements that are collateralized by cash or government securities.

Think of repurchase agreements (“repo”) as a deal with a pawn shop. Entities give collaterals to the money market fund for short-term cash. They’ll come back later to buy back (“repurchase”) their collaterals at a higher price. If they don’t fulfill the repurchase agreement, the money market fund will sell those collaterals. Repurchase agreements aren’t guaranteed by the government. Their safety comes from the collaterals.

A government money market fund is safer than a prime money market fund. Fidelity Treasury Only Money Market Fund (FDLXX) is the safest because it invests more in Treasuries. It pays a little less though.

The income earned from these two funds is fully taxable at the federal level. A percentage of the income is exempt from state income tax. That percentage varies from year to year.

Minimum InvestmentState Tax Exemption in 2022Fidelity Government Money Market Fund Premium Class (FZCXX)$100,000 ($10,000 in IRA)31% (0% in CA, NY, CT)Fidelity Treasury Only Money Market Fund (FDLXX)$094%

Among the seven taxable money market funds, if you value the convenience of no extra step to buy, you can leave the money in one of the core-eligible funds. If you want a higher yield and you’re not concerned about the slightly higher risk, you can go with one of the prime money market funds (FZDXX or SPRXX). If you want the most solid peace of mind at the cost of a slightly lower yield, you can choose the Treasury Only fund (FDLXX) for extra safety and the additional state income tax savings. Finally, the Government Money Market Fund Premium Class (FZCXX) is a good middle ground with safer holdings than the prime funds and you’re not giving up too much yield. I have my cash in FZCXX.

Remember to claim the state tax exemption when you do your taxes. See State Tax-Exempt Treasury Interest from Mutual Funds and ETFs.

Single State Tax-Exempt Money Market Funds

Fidelity offers tax-exempt money market funds specifically for investors in higher tax brackets in California, Massachusetts, New Jersey, and New York. These funds invest in high-quality, short-term municipal securities issued by entities within the state. Income from these funds is tax-exempt from both the federal income tax and the state income tax. They’re sometimes called “double tax-free” funds.

The fund for each state has two share classes — a regular share class and a Premium Class. The Premium Class fund requires a $25,000 minimum investment. The regular class fund has no minimum but it pays a little less because it has a higher expense ratio (0.42% versus 0.30%).

Regular Share Class
($0 minimum)Premium Class
($25,000 minimimum)CaliforniaFABXXFSPXXMassachusettsFAUXXFMSXXNew JerseyFAYXXFSJXXNew YorkFAWXXFSNXX

The yield on these single state tax-exempt money market funds is lower than the yield on the seven taxable money market funds but the federal and state tax exemption makes up for it when you’re in a high tax bracket.

Remember to claim the state tax exemption when you do your taxes. See State Tax-Exempt Muni Bond Interest from Mutual Funds and ETFs.

National Tax-Exempt Money Market Fund

Fidelity offers three tax-exempt money market funds for investors in higher tax brackets outside of California, Massachusetts, New Jersey, and New York. These funds are more diversified than the eight single-state funds because they invest in short-term, high-quality municipal securities from many states.

Expense RatioMinimum InvestmentFidelity Municipal Money Market Fund (FTEXX)0.41%$0Fidelity Tax-Exempt Money Market Fund (FMOXX)0.47%$0Fidelity Tax-Exempt Money Market Fund Premium Class (FZEXX)0.37%$25,000

Income from these funds is tax-exempt from the federal income tax but only a small percentage is exempt from state income tax. The yield is lower than the yield on the seven taxable money market funds but the federal income tax exemption makes up for it when you’re in a high tax bracket. If you live in California, Massachusetts, New Jersey, or New York, you can still invest in these national funds if you don’t mind paying more in state income tax.

Remember to claim the small state tax exemption when you do your taxes. See State Tax-Exempt Muni Bond Interest from Mutual Funds and ETFs.

Taxable or Tax-Exempt?

A tax-exempt money market fund offers tax savings but it pays less. Choose a tax-exempt fund if you’re in a high tax bracket. Choose a taxable fund if you’re in a low tax bracket. If you’re not sure whether your federal and state tax brackets are considered high or low, you can use a calculator to see which fund offers a better yield after taxes.

Yield Swings

A wrinkle in comparing taxable and tax-exempt money market funds is that the yield on tax-exempt money market funds swings wildly throughout the year. This chart shows the yield on a taxable money market fund and the yield on a tax-exempt money market fund over a 12-month period:

While the yield on the taxable fund (green line) rose steadily over time as the Fed raised interest rates, the yield on the tax-exempt fund (orange line) swung wildly up and down. If you happen to compare the after-tax yields when the yield on the tax-exempt fund is near a top, it would show that the tax-exempt fund is better even in a low tax bracket. If you happen to compare them when the yield on the tax-exempt fund is near a bottom, it would show that the taxable fund is better even in a high tax bracket.

MM Optimizer

So you can’t just adjust for taxes based on the yields at this moment. You need to look over a longer period to take into account the wild swings in tax-exempt funds.

User retiringwhen on the Bogleheads forum created a Google Sheet that does this. It’s called MM Optimizer. Although the current version of this tool focuses on Vanguard money market funds, it’s also informative when you use a Fidelity money market fund. If the tool shows that a Vanguard taxable money market fund is better than a Vanguard tax-exempt fund at your tax rates, it’s highly likely that a Fidelity taxable money market fund is also better than a Fidelity tax-exempt fund for you at the same tax rates.

The author of MM Optimizer is considering adding support for Fidelity money market funds. It’s possible that a future version of MM Optimizer will include Fidelity money market funds as well.

Your Tax Rates

MM Optimizer is a shared as View Only. After you make a copy of it to your Google account, you change the tax rates on the My Parameters tab to your tax rates.

My Parameters tabCompare After-Tax Yield

The My Charts tab shows the after-tax yield of different funds over the last 12 months. You can watch the yields and switch back and forth between a taxable fund and a tax-exempt fund but I wouldn’t bother. The chart shows how many times you would’ve had to switch to catch the temporary swings and how short-lived each switch was.

My Charts tab

I would take a look at this chart and see which line is on top most of the time. Choose a Fidelity taxable money market fund and stay with it if the chart shows that the smoother line is on top most of the time. Choose a Fidelity tax-exempt money market fund if the chart shows that the bouncy line is on top most of the time.

MM Optimizer has a lot more features but you don’t have to get into those. It’s simple to use if you only look at the places I’m showing here. The author is still adding new features. I hope it will include Fidelity money market funds soon. You’ll find the link to the latest version in this post on the Bogleheads forum.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on April 11, 2023 07:39

April 5, 2023

Which Vanguard Money Market Fund Is the Best at Your Tax Rates

As I wrote in No FDIC Insurance – Why a Brokerage Account Is Safe, when you keep your cash in a money market fund at a broker, the safety of your money doesn’t depend on the financial health of the broker. The safety comes directly from the safety of the holdings in the money market fund. Your money market fund is safe when the fund’s underlying holdings are safe.

Table of ContentsWhy Money Market FundWhy VanguardTaxable Money Market FundsSingle State Tax-Exempt Money Market FundsNational Tax-Exempt Money Market FundTaxable or Tax-Exempt?Why Money Market Fund

The reason to keep your cash in a money market fund, as opposed to a high yield savings account, is that you’re not depending on any bank to set their rate competitively. You automatically get the market yield minus the fund manager’s cut, no more, no less, sort of like when you invest in an index fund. You’re not moving to another bank because it’s offering a promotional rate. You’re not moving again when that bank decides to lag behind. See my Guide to Money Market Funds & High Yield Savings Accounts.

Why Vanguard

Because all money market funds of the same type fish in the same pond, how much the fund manager charges to run the fund (the “expense ratio”) directly affects how much yield you’ll receive. Among the major brokers, Vanguard charges the lowest expense ratio on its money market funds. Even if you do your investing elsewhere, you can still open a Vanguard account just to use its money market fund in the same way you use a high yield savings account — transfer money into it when you have excess cash and transfer money out when you need cash.

Vanguard offers six money market funds of three different types. They differ in their underlying holdings and tax treatment at both the federal and the state levels. Which one will be slightly better for you than another depends on your preference for convenience and your federal and state tax brackets.

Taxable Money Market Funds

Three of the six Vanguard money market funds are taxable money market funds. You pay federal income tax on the income earned from these funds. A portion of the income earned is exempt from state income tax.

The yield from any of these three funds is very close to each other. The quoted yield on any money market fund is always a net yield after the expense ratio is already deducted. You don’t need to deduct it again.

Vanguard Federal Money Market Fund

Vanguard Federal Money Market Fund (VMFXX) is the settlement fund in a Vanguard brokerage account. You don’t have to do anything extra to buy or sell this fund. It requires no minimum investment. Any cash you transfer into your Vanguard brokerage account will automatically land in this fund. Any cash you transfer out of your Vanguard brokerage account will come out of this fund by default.

The income earned is fully taxable at the federal level. A percentage of the income is exempt from state income tax. That percentage varies from year to year. It was 38% in 2022 (0% for CA, NY, and CT residents).

This fund invests in government securities and repurchase agreements that are collateralized by government securities. Think of repurchase agreements (“repo”) as a deal with a pawn shop. Entities give government securities to the money market fund as collateral for short-term cash. They’ll come back later to buy back (“repurchase”) their government securities at a higher price. If they don’t fulfill the repurchase agreement, the money market fund will sell those government securities. Repurchase agreements themselves aren’t guaranteed by the government but their safety comes from the safe collateral.

Vanguard Treasury Money Market Fund

Vanguard Treasury Money Market Fund (VUSXX) invests primarily in Treasuries. It’s the safest money market fund at Vanguard. You have to enter a buy or sell order to get money into or out of this fund. It has a $3,000 minimum investment. The $3,000 minimum is only required to get started. You can transfer in and out less than $3,000 after you have the fund.

The income earned from the Treasury Money Market Fund is fully taxable at the federal level. A percentage of the income is exempt from state income tax. That percentage varies from year to year. It was 100% in 2022 but it will likely be in the 70% range in 2023.

Vanguard Cash Reserves Federal Money Market Fund

Vanguard Cash Reserves Federal Money Market Fund (VMRXX) is somewhere in between the Federal Money Market Fund and the Treasury Money Market Fund. As in the Treasury Money Market Fund, you have to enter a buy or sell order to get money into or out of this fund. It also has a $3,000 minimum investment.

This fund invests more in Treasuries than the Federal Money Market Fund but less than the Treasury Money Market Fund. The income earned is fully taxable at the federal level. A percentage of the income is exempt from state income tax. That percentage varies from year to year. It was 53% in 2022 (0% for CA, NY, and CT residents).

Must Buy/SellState Tax-Exemption in 2022Federal Money Market (VMFXX)no38% (0% in CA, NY, CT)Treasury Money Market (VUSXX)yes100% (likely ~70% in 2023)Cash Reserves (VMRXX)yes53% (0% in CA, NY, CT)

Among these three taxable money market funds, If I value the convenience of no extra step to buy or sell or if I live in a no-tax state, I would choose the Federal Money Market Fund (VMFXX). If I don’t mind the extra step to buy or sell and I live in a high-tax state, I would choose the Treasury Money Market Fund (VUSXX) for extra safety and the additional state income tax savings.

Remember to claim the state tax exemption when you do your taxes. See State Tax-Exempt Treasury Interest from Mutual Funds and ETFs.

Single State Tax-Exempt Money Market Funds

Vanguard offers a tax-exempt money market fund specifically for California and New York residents in higher tax brackets. These two funds invest exclusively in high-quality, short-term municipal securities issued by entities within the state. Income from these funds is tax-exempt from both the federal income tax and the California and New York state income tax respectively. They’re sometimes called “double tax-free” funds.

Both Vanguard California Municipal Money Market Fund (VCTXX) and Vanguard New York Municipal Money Market Fund (VYFXX) require a buy or sell order to get money into and out of the fund. Both require a $3,000 minimum investment.

The yield on these funds is lower than the yield on the three taxable money market funds but the federal and state tax exemption makes up for it when you’re in a high tax bracket.

Remember to claim the state tax exemption when you do your taxes. See State Tax-Exempt Muni Bond Interest from Mutual Funds and ETFs.

National Tax-Exempt Money Market Fund

Vanguard Municipal Money Market Fund (VMSXX) is for investors in higher tax brackets outside of California and New York. This fund is more diversified than the California and New York funds because it invests in short-term, high-quality municipal securities from many states. Income from this fund is tax-exempt from the federal income tax but only a small percentage is exempt from state income tax.

It also requires a $3,000 minimum investment and a buy or sell order to get money into and out of the fund. The yield on this fund is lower than the yield on the three taxable money market funds but the federal income tax exemption makes up for it when you’re in a high tax bracket.

Remember to claim the small state tax exemption when you do your taxes. See State Tax-Exempt Muni Bond Interest from Mutual Funds and ETFs.

Taxable or Tax-Exempt?

A tax-exempt money market fund offers tax savings but it pays less. Choose a tax-exempt fund if you’re in a high tax bracket. Choose a taxable fund if you’re in a low tax bracket. If you’re not sure whether your federal and state tax brackets are consider high or low, you can use a calculator to see which fund offers a better yield after taxes.

I created such a calculator back in 2007. I was going to update it but I came across a much more elaborate one created by user retiringwhen on the Bogleheads forum. It’s a Google Sheet called MM Optimizer.

Your Tax Rates

MM Optimizer is a shared as View Only. After you make a copy of it to your Google account, you change the tax rates on the My Parameters tab to your tax rates.

My Parameters tabBest Right Now

MM Optimizer automatically pulls in the latest yield numbers. The My Best Now tab shows you which fund has the highest after-tax yield right now for the tax rates you entered.

My Best Now tab, Cells A5 to I12

In this example, it shows that the national tax-exempt fund has the highest after-tax yield, although not by much over the Treasury money market fund (3.57% versus 3.49%, or 5.25% versus 5.13% in pre-tax terms).

Best Last 12 Months

A wrinkle in comparing taxable and tax-exempt money market funds is that the yield on tax-exempt money market funds swings wildly throughout the year. This chart shows the yield on a taxable money market fund and the yield on a tax-exempt money market fund over the last 12 months:

Pre-Tax Rate Chart tab

While the yield on the taxable fund (green line) rose steadily over time as the Fed raised interest rates, the yield on the tax-exempt fund (orange line) swung wildly up and down. If you happen to compare the after-tax yields when the yield on the tax-exempt fund is near a top, it would show that the tax-exempt fund is better even in a low tax bracket. If you happen to compare them when the yield on the tax-exempt fund is near a bottom, it would show that the taxable fund is better even in a high tax bracket.

MM Optimizer shows which fund was better at your tax rates if you stuck to it over a full year.

My Best Now tab, Cells N15 to Q17

In this case, the Treasury money market fund was better for the full year even though the tax-exempt fund is slightly better at this moment only because the yield on the tax-exempt fund is near a top.

Switching Back and Forth

You can watch the yields and switch back and forth between a taxable fund and a tax-exempt fund but I wouldn’t bother. The My Rate Chart tab shows how many times you would’ve had to switch to catch the temporary swings and how short-lived each switch was.

My Rate Chart tab

I would take a look at this chart and see which line is on top most of the time. Choose that fund and stay with it. In this example, it’s the Treasury money market fund (green line).

MM Optimizer has a lot more features but you don’t have to get into those. It’s simple to use if you only look at the places I’m showing here.

Learn the Nuts and Bolts My Financial Toolbox I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

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Published on April 05, 2023 16:03

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