5 Strategies For Optimizing Cash Tax Efficiently After A Liquidity Event
Whether you are on the verge of an IPO, have just experienced a liquidity event through a tender offer, or have been building up cash for a specific goal, you may be wondering, how you can optimize what you doing with your cash, above and beyond using a high-yield savings account. Here are some of the options I’ve been discussing with clients lately and have been using in client accounts to optimize large cash holdings (above $100k) with a focus on tax efficiency.
1) Certificates of Deposit (CDs). Typically, CDs, like bank accounts, are FDIC insured up to $250,000, and for short-term needs can be purchased with 3-18 month durations. If you intend to hold more than 250k, consider purchasing multiple CDs, and perhaps laddering your timelines (i.e. buy 3, 6, 9, and 12-month CDs). Laddering CD durations allows you to create windows of liquidity but can also increase the time you’ll need to devote to managing cash. Some banks have an automatic re-enrollment feature, that will roll an expiring CD into a new one of the same duration.
It’s worth noting that most CDs carry a 1-3 month interest penalty for premature withdrawals. This means that if you lock in a 12-month CD, then unexpectedly need the cash and pull it out after month 6, you could effectively still receive the first 3 months of interest. CD and bank interest is taxable as ordinary income on both the state and federal level, making CDs and saving accounts some of the least tax-efficient places to hold cash.
2) Purchase 3-month treasury notes directly. With short-term treasuries climbing above 5%, this can provide a highly liquid tax-efficient place to park cash for a few months. Purchasing treasuries can be accomplished through the Department of Treasury, or with the help of a broker or financial advisor. Treasuries are taxable at the federal level but not at the state level.
3) Utilize a municipal money market fund such as Vanguard’s VMSXX or Fidelity’s FMOXX. Money market funds are designed to maintain their value and safety of principle and ongoing stable income. The underlying investments within municipal money market funds are structured to deliver income Federally tax-free. Using such a fund becomes particularly advantageous if you find yourself in the highest 37% Federal tax bracket, either because of ongoing high compensation or due to a major liquidity event. Unlike a CD, or a savings account, where you will lose 37 cents on every dollar of income you earn, muni money market funds protect that income from tax.
4) Invest cash in a short-to-medium-term state-specific municipal bond fund. State-specific muni bond funds differ from muni money market funds in that they fluctuate in value with the interest rate environment and that they are designed to provide income tax-free on both the state and federal levels. State-specific funds such as Vanguard’s VCAIX, or Schwab’s SWCAX, are designed to be held by investors within a specific state. Dividend distributions from these funds are received income tax-free on both the state and Federal levels. At the time of writing, VCAIX had an SEC yield of 3.04% and an average coupon of 4.2%.
The value of this tax-free income becomes apparent in consideration of tax-equivalent yield. If you are in the highest CA (12.3%) and Federal (37%) tax brackets, a 5% interest rate on CD effectively creates just 2.54% of after-tax income. In those tax brackets, utilizing a state-specific municipal bond fund could boost your after-tax return by more than a percentage point.
5) Invest it. If the goal is to keep ahead of inflation over the long term, then cash is not your friend. Without a specific spending need or target date for spending your cash, over the long term, the data says that one of the most effective ways of building and maintaining wealth over the long term is to move money out of cash and invest it. Investing in a diversified long-term portfolio where dividends and capital gains will ultimately be taxed at preferential long-term capital gains rates creates both a greater opportunity for growth as well as tax efficiency on this compounding growth.
A Word On Liquidity Events
As I’ve worked with people receiving cash influxes, I’ve found that there can be a significant psychological barrier to putting cash “at risk” right after a major liquidity event. Liquidity can create paralysis. The best way to overcome this is often to think through your specific short and medium goals. Ensure you have more than you need for those goals in safe cash, and then begin to release the rest of the funds to your future self through an investment plan. If you feel tentative about doing so, perhaps building your financial knowledge could help. That’s part of my job. If you’re caught in ‘yes, I think it’s the right thing to do to invest, but…’ internal conversation, I’m here to support you and be your thought partner.
A Word On FDIC insurance.
It’s best practice to ensure that each of your bank accounts and CDs holds less than $250,000. Why? Because the Federal Deposit Insurance Corporation, a United States government corporation, supplies deposit insurance to depositors in American commercial banks and savings banks up to that amount on each account. If your bank were to fail (as some have recently), your cash balance is insured. Above $250,000 your deposits are unprotected by this insurance coverage.
A Word On Systematically Handling Cash
There are excellent reasons to hold significant cash. Leaving a job, covering a tax bill, planning for a home remodel, college, or a business investment are all reasons to hold large cash positions thoughtfully. But it typically shouldn’t be a default. Knowing your monthly cash flow, and then setting up automatic deposits to your savings account above and beyond your needs is one of the typical ways I see people automate avoiding building up unnecessary large cash accounts. When you can, automate it.