As short-term interest rates soar and banking fears rise, more investors are stashing their cash in short-term Treasury securities, either directly or through government money market funds.

Last month, yields on six-month Treasury bills topped 5% for the first time in 16 years only before a burst of panic buying in the wake of Silicon Valley Bank’s failure pushed yields below that threshold this week.

In addition to being backed by the U.S. government, the interest on Treasury securities is exempt from state (but not federal) income taxes. That’s a nice perk in California, where the top tax rate is 13.3%, highest in the nation.

If you buy Treasurys directly – through a brokerage account or the government website TreasuryDirect.gov – you’ll pay federal tax on the interest but can deduct it on your California tax return.

If you own shares in a government mutual fund, you generally can deduct on your state taxes the percentage of annual dividends that came from Treasurys and a small number of other government securities.

However, if you live in California, New York or Connecticut, which have a tougher rule for these dividends, you may get no state-tax deduction. 

This was especially true in 2022, as some California investors may discover when they prepare their tax returns. 

For example, T. Rowe Price has two government money funds: Government Money and U.S. Treasury. On their 2021 returns, shareholders everywhere could deduct 86% and 87% of their dividends, respectively. For 2022, shareholders in most states could deduct only 27% and 21%, respectively. But those in California, New York and Connecticut got zero state-tax exemption.

To understand why, it’s important to know what these funds invest in, their confusing nomenclature and California’s special rule.

Money market funds invest in short-term, high-quality securities. Although they’re not guaranteed, they’re generally considered a relatively safe place to put money you may need within a few years. They are sold by mutual fund companies and should not be confused with money market deposit accounts offered by banks, which are guaranteed, up to a limit, by the Federal Deposit Insurance Corp. 

There are three types of money market funds.

• “Prime” funds hold cash and securities issued by the government, government agencies, corporations and in certificates of deposit. Their dividends are largely taxable at the federal and state level. You won’t find government or Treasury in their names.

• “Municipal” or “tax-exempt” funds buy securities issued by state and local governments.  Their dividends are exempt from federal tax, and from state tax to the extent they came from securities issued in your home state.

• “Government” funds normally invest at least 99.5% of assets in cash, U.S. government securities and/or repurchase agreements that are fully collateralized by cash or government securities. 

Some of these U.S. government securities are exempt from state and local taxes, namely Treasurys and a limited number of government-agency securities. Other government securities, such as those issued by Fannie Mae and Freddie Mac, are not exempt from state and local tax.  Repurchase agreements are also not exempt. Nicknamed “repos,” these are essentially short-term – often overnight – lending agreements.

“Treasury” money market funds are a type of government fund that normally invest in cash, Treasurys and/or Treasury-backed repos, but not other government securities. Funds labeled “Treasury Only” or “100% Treasury” generally invest only in Treasurys, not repos.

Each year, fund companies issue a report showing the percentage of dividends that came from government securities eligible for a state-tax exemption, so shareholders can figure out how much of their federally taxed dividends they can deduct on their state return.

For example, if 80% of a fund’s dividends came from eligible securities (primarily Treasurys),  80% of dividends are generally exempt from state tax. 

California, however, only allows a state-tax exemption if at least 50% of the fund’s assets at the end of each calendar quarter were in these eligible government securities. (New York and Connecticut have this same rule.)

If the fund meets that 50% of assets test, then shareholders in these three states can deduct whatever percentage of dividends came from eligible securities, just like shareholders in other states.

But if the fund fails the 50% test, none of its dividends are exempt from state tax in the three states.

In 2022, many government money funds shifted a much larger percentage of assets from Treasurys (which are state-tax exempt) into repurchase agreements (which are not). 

As a result, shareholders in many government money funds got a much smaller state-tax deduction. And because of the 50% rule, many in California got zero deduction.

Let’s take a look at Vanguard’s Federal and Cash Reserves Federal money funds, which are the nation’s largest and third-largest government money funds, respectively, according to Crane Data.

In 2021, they each derived almost three-fourths of dividends from eligible government securities. And both met the 50% of assets test, so investors in all states could deduct nearly three-fourths of their dividends on their state-tax returns.

But in 2022, Vanguard Federal and Cash Reserves Federal got only 38% and 53% of dividends, respectively, from eligible securities. Both failed the 50% test, so shareholders in California, New York and Connecticut got no state-tax deduction, while investors in other states could deduct 38% of dividends and 53% of dividends, respectively.

Notice that a fund, like Cash Reserves, could get more than 50% of its dividends from Treasurys but still fail the 50% of assets test. 

Investors in the firm’s third government fund, Vanguard Treasury, could deduct 100% of dividends in 2021 and 2022.

So why did so many fund managers favor repos over Treasurys last year, which cut into state-tax deductions?

Money market funds can enter into repurchase agreements with the Federal Reserve Bank of New York as part of its program to maintain the target federal funds rate. These agreements are backed by the New York Fed’s Treasury holdings. Most other investors cannot access this program.

During the pandemic, “you had a ton of stimulus money coming into the system,” said Doug Spratley, a T. Rowe Price fund manager. Municipalities, corporate treasurers and individuals who had excess cash gobbled up short-term Treasurys. This “pushed yields on Treasury bills below overnight repos, sometimes by one-fourth of a percent or more,” he said. 

So money funds piled into the New York Fed’s repurchase program.

Also, when interest rates are rising, investors want to be in short-term securities, so when their investments mature, they can reinvest at higher rates. Overnight repos are the shortest term possible.

The New York Fed program “is the single biggest holding in money funds now,” said Peter Crane, publisher of Money Fund Intelligence.

Buying a “Treasury” money fund doesn’t guarantee a tax exemption in California because many of these funds can invest in repos.

California investors who want a guaranteed state-tax deduction should look for money funds that invest in Treasurys only, not repos. Sometimes you can tell by their names (such as 100% Treasury or Treasury Only), but not always.

For example, the Schwab Treasury Obligations Money Fund invests in repurchase agreements while the Schwab U.S. Treasury Money Fund does not, Schwab spokesman Mike Peterson said via email.

Investors should also compare the yields on Treasury-only funds to other government and prime funds. 

Normally, yields on Treasury-only funds lag yields on funds that can buy repos and other government securities, but they could still be higher on an after-tax basis. Today, their yields are very close.

As of Monday, the average seven-day yield for retail money funds was 4.33% for prime funds, 4.06% for government funds and 4.12% for Treasury funds (including Treasury-only funds), according to Crane Data.

Investors can also guarantee themselves a state-tax deduction by buying Treasurys directly, but they’ll have to take charge of reinvesting the proceeds as they mature, unless they set up automatic reinvestment.

Normally, a Treasury-only money market fund would be considered one of the safest bets out there. But because of the looming fight in Congress over the federal debt ceiling, there are some concerns.

Treasury-only money funds “have higher relative risk to a U.S. government default than prime and government (money funds) that can diversify investments into other instruments,” Fitch Rating said in a report.  (Fitch is owned by Hearst, which also owns The Chronicle.)

Since Jan. 19, when the U.S. government hit its debt limit, the U.S. Treasury has been using extraordinary measures to meet its obligations. At some point, called the X date, it will exhaust those and could conceivably default on some obligations, including Treasury securities.

The X date is likely between July and September, but could hit as early as June.

Treasury-only funds “could face increased volatility in the Treasury market and heightened investor redemptions as the debt ceiling deadline approaches,” Fitch wrote.

To reduce this risk, fund managers would likely cut back on Treasurys maturing around the expected X date, Fitch said. It currently expects the ceiling will be raised or suspended to avoid a default, although that opinion could change.

Pete Gargiulo, a director with Fitch, said he can’t give investment advice, but “if you are buying Treasury bills directly,” the debt ceiling “is a consideration. The timing can be very challenging.” He said “fund managers have been through debt-ceiling standoffs before. They have navigated these waters. That’s one benefit of being in a Treasury-only money market fund.”

But Crane said he doesn’t think the “state-tax bonus” of being in a Treasury-only fund is worth the risk. “Wait until after the debt ceiling is raised, or better yet, buy a California municipal money market fund,” he said.

California announced Thursday that it will follow the lead of the Internal Revenue Service and extend tax filing deadlines to Oct. 16 for almost all people and businesses in the state.

Those taxpayers will have until Oct. 16 to file their 2022 federal and state income tax returns and pay any taxes due without penalty. The new deadline also applies to other tax payments this year.

The Internal Revenue Service has further extended its tax filing deadline for Californians affected by the winter storms pounding the state — which means the entire Bay Area and most of the rest of the state have until the fall to file and pay their federal taxes. 

The agency set Oct. 16 as the new deadline for eligible individuals to file their 2022 federal individual and business tax returns and to make tax payments, the IRS announced Friday. Residents, households and business owners in 44 California counties listed in a federal emergency declaration earlier this year are eligible for the extension. All nine Bay Area counties are on the list, along with the rest of the state's major population centers.