Experts say that if you funnel cash into money market mutual funds in 2023 amid rising interest rates, you may have a surprise tax bill in April.
Investors and institutions have piled $5.84 trillion into money market mutual funds as of Nov. 29, according to the Investment Company Institute, and many funds are paying well over 5%.
“With pennies earned in 2022 on cash assets, the tax bill was negligible,” said certified financial planner Robert Schultz, senior partner at NWF Advisory Group in Encino, California. “At 5% rates, there will be much higher bills, catching many off guard.”
With yields closely tied to the federal funds rate, money market funds — different than money market deposit accounts — are mutual funds that typically invest in shorter-term, lower-credit-risk debt, such as Treasury bills.
Many investors are stockpiling money into these funds due to “fear in the stock market,” and many are nervous about spending cash, according to CFP Colin Day, an enrolled agent at Correct Capital in St Louis.
Fund earnings ‘could be significant’
Typically, money market funds pay dividends monthly, and the earnings made in 2023 “could be significant,” said Day. “But unfortunately, this is before taxes.”
Rather than more favorable capital gains rates, you’ll owe regular income taxes on money market fund earnings, with a top bracket of 37%. By comparison, the top long-term capital gains rate is 20%.
For example, let’s say you’re an investor in California with a 45% tax rate when combining state and local taxes. According to Schultz, earning $100,000 in a money market fund, earning 5% could trigger a $2,250 tax bill.
However, some states offer a tax break, depending on the underlying assets. For example, money market funds with U.S. Treasury bonds may exclude a portion of earnings from state and local taxes.
Still, investors may only learn about their taxable money market earnings when they receive tax forms in early 2024. “There will be a late Christmas gift for many investors in February,” Schultz said.
Typically, investors receive tax forms for money market mutual funds in January or February, which report the previous year’s earnings to the IRS.
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