T-Bills and money markets are both popular choices for investors looking to earn interest from their cash. T-Bills are simple and straightforward. T-Bill interest is state tax exempt. Money markets are more complicated. Money markets come in two forms, money market accounts and money market mutual funds.
Money Market Accounts vs Money Market Mutual Funds
Investors choosing between a money market account at a bank and money market mutual fund will usually do better with a money market mutual fund.
Money market accounts are deposit accounts offered by banks. They are FDIC insured up to $250,000. Money market accounts will pay an interest rate specified by the bank. Typically, the interest rate you receive is going to be on a sliding scale relative to the amount of money you have at the bank. To qualify for the best rate, you will need to have a certain level of funds kept at the bank. The account funding requirement to earn the best money market account rate could easily be $100,000 or more. The biggest drawback to a money market account is that 100% of the interest will be taxable at the state level.
Money Market Account Pros
- FDIC Insurance
Money Market Account Cons
- Deposit account, your bank is loaning your money out.
- Protection is limited to $250,000.
- Interest will be fully taxable at the state level.
- Interest rates are often less than T-Bills.
- High account minimums are often imposed to get the best interest rate.
- You become a target for bank sales reps pushing investment products.
Money Market Mutual Funds
Money market mutual funds can be purchased through brokerage firms like Fidelity. Examples of money market mutual funds are Fidelity Government Cash Reserves Fund FDRXX and the Fidelity Government Money Market Fund SPAXX. Unlike bank deposit accounts, there are no minimum investment amounts. Every investor receives the same interest rate in the fund, regardless of the amount of money they have invested. The biggest benefit of a money market mutual fund vs a money market account at a bank is that a portion of the money market mutual fund interest will be state tax exempt. The reason that a portion of the money market mutual fund interest is state tax exempt is that money market mutual funds invest in T-Bills. The negative for a money market mutual fund is research you need to perform to claim your state income tax deduction for the T-Bill interest in the fund. Your custodian will send you a 1099 that will show the interest you received from your money market mutual fund, but it will not show what amount is from T-Bills. To properly file your state income tax return, you must go to the money market mutual fund administrator’s website and research the fund’s tax information. You will need to determine the percentage of your interest from the fund that was generated by T-Bills and enter the corresponding deduction on your state income tax return. Most investors and their accountants miss this important tax reporting step and end up paying tax on interest that should be state tax exempt.
Money Market Mutual Fund Pros
- No minimum investment amount.
- Competitive interest rates often exceed money market accounts.
- A portion of your interest will be state tax exempt.
- Liquid.
- A portion of the fund will be in T-Bills which are very safe.
Money Market Mutual Fund Cons
- The percentage of your interest that is state tax exempt is not on your 1099.
- Expense ratio inside the fund.
T-Bills. A Great Choice for Safe Investing
T-Bills are an excellent investment for earning interest. T-Bills are zero coupon bonds. You buy them at a discount, and they mature at the par value of $1,000 per bill. The discount you receive when buying a T-Bill is the interest that will be reported on your 1099. For example, you buy a T-Bill for $950, and it matures at $1,000. You will earn $50 in interest.
Holding your T-Bill until maturity guarantees you will receive $1,000 per bill when the bill matures. It is possible that you could lose money on a T-Bill if you had to sell the T-Bill prior to maturity. A situation where you could lose money on a T-Bill would arise if you bought a T-Bill and then after your purchase, interest rates climbed, and you had to sell after interest rates went up.
T-Bills require you to learn how to buy and sell bonds through a brokerage firm or to open an account at Treasury Direct. Once you get past the learning curve, you are on your way to earning interest that is state tax exempt!
T-Bill Pros
- 100% state tax exempt.
- No fees if you buy them from Treasury Direct.
- Very low fees if you buy them from a brokerage firm.
- Interest rates often beat money market accounts and money market mutual funds.
- Different maturities available.
- You can lock in an interest rate for a specified period.
T-Bill Cons
- Learning curve for buying bonds from a brokerage firm.
- Ongoing management of the bills. As they mature, you need to buy new bills.
- Potentially you could lose money if you needed to sell before maturity; rare.
If you have questions about your investments, please give our office a call. We would be happy to give you a free second opinion on your portfolio.
Ethan S. Braid, CFA
President
HighPass Asset Management
Denver, CO