In today's interest rate environment, holding a significant amount of cash isn't an unreasonable position to take.
While long-term investors will likely maximize their returns by buying and holding stocks, those needing cash in the near term or building an emergency fund are smart to hold cash. With high-yield savings accounts offering interest rates of 5% or more, you're earning a solid real return on your cash savings these days.
But if you're looking to get more out of your cash holdings while you wait for an opportunity to use it, you might be able to do better than a simple savings account. The trick is to make your cash savings more tax-efficient.
Here are two exchange-traded funds (ETFs) that use different tax strategies to offer better after-tax returns than savings accounts for some investors -- and without much additional risk.
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1. Short-term Treasury bonds
Treasury bonds pay interest just like any other bond. However, the interest earned from U.S. Treasuries is exempt from state income tax. Note that you'll still pay federal income tax, but if you live in a high-tax state like California, not paying state taxes can be a big savings boost.
If you want to protect your cash from interest rate risk, which could impact bond prices, using short-duration Treasury bills is about as ironclad as it gets in the bond market. It's Warren Buffett's favorite place to park cash.
One ETF that can help you easily invest in short-term Treasury bills is the iShares 0-3 Month Treasury Bond ETF (SGOV 0.02%). The fund invests in Treasuries with less than three months remaining until maturity. It pays out distributions every month, similar to a savings account, and 96.45% of those distributions were exempt from state taxes in 2023.
The fund charges a minuscule expense ratio of just 0.07%, so you won't pay much to hand off the investment process to the professionals. Consider using this ETF to stash your cash if you live in a high-income-tax state.
2. Municipal bonds
While Treasuries are exempt from state income tax, municipal bonds (or munis) are exempt from federal income tax. In some instances, interest from munis is also exempt from state and local taxes.
Again, focusing on short-term bonds is key to reducing the impact of interest rate changes on the value of your investments. One of the few ETF options focused on short-term municipal bonds is the JPMorgan Ultra-Short Municipal Income ETF (JMST -0.02%). It invests in a broad portfolio of muni bonds with both fixed and variable rates maturing within 12 months.
The fund pays out distributions every month, which are exempt from federal income tax. It charges an expense ratio of just 0.18%.
Investors should be aware that the yield on municipal bonds is much lower than on Treasury bonds. Currently munis yield about two percentage points less than treasuries. That means you'll need to determine whether the tax advantages are worth the lower yield. If you're in a high tax bracket, it might be.
Are the tax advantages worth it?
Every individual's circumstances are different. The tax savings from using government bonds can be substantial for some but minuscule for others. It's important to do a little bit of math to figure out whether the investments above are worth it. In most cases you could save at least a little bit, but it might not be worth the hassle for those with low tax brackets or just a small amount of cash savings.