Short-term Tax-exempt fund?

[Khisanth]

I'm in the 35% tax bracket, and was wondering whether it might make better sense to go into a short-term tax-exempt municipal fund such as Vanguard Short-Term Tax-Exempt Admiral shares VWSUX (~1% yield) for the Cash portion of my portfolio.

I live in California as well, so any reduction in California Taxes would be appreciated, although I don't think I want to use Intermediate-Term munis as a Cash equivalent, which is the shortest California tax-exempt bond fund that Vanguard offers. I suppose there's the Money-Market, but that yield is a meager 0.03%.

[moda0306]

States are like Greece and have credit risk... especially states who always seem to have budget issues like California.

Treasuries will be state-tax free.

Also, with i-bonds and ee-bonds you should be able to build up a nice supply of "tax-deferred" cash that returns much higher than most s-t treasury bonds.

[KevinW]

Browne's position was that the market bids up municipal bonds to the point that almost all of the tax benefit is gone anyway.  And as moda said they are already exempt from state tax.  So munis don't improve after-tax returns very much and introduce a significant amount of credit risk to the cash allocation.  Also remember that cash is intended to be rock solid in severe recessions, and in those conditions local governments are more likely to default and the liquidity of T-bills is more important than ever.

[Reub]

Is SHY "rock-solid"?

[KevinW]

Well, the Treasuries SHY holds are rock solid.  There is a little bit of counterparty risk from iShares and liquidity risk from the ETF structure.

[Reub]

So then, why aren't bank CD's more solid? Aren't they FDIC insured with no possible loss of principle?

[KevinW]

So then, why aren't bank CD's more solid? Aren't they FDIC insured with no possible loss of principle?

The FDIC has a finite budget and could run out of money in a bank crisis.  One of the first Google autocompletions for FDIC is "fdic fund running dry" and one of the first hits is this post http://www.zacks.com/stock/news/20514/F ... unning+Dry from 2009 that says

At the end of the quarter, the Deposit insurance fund was at just $13.0 billion, or 0.27% of insured deposits, a decline of 24.7% in the quarter alone.

It's safer to just hold T-bills which are free of credit risk, without any of this fine print.

[Reub]

Wouldn't the feds just print more money to make their FDIC guarantee good?

[Lone Wolf]

Wouldn't the feds just print more money to make their FDIC guarantee good?

I tend to be almost certain that you're right about this.

Still, a part of me is nagged by the idea that in a really awful situation, accounts could be frozen for a long time if you haven't got that explicit guarantee that you get with a T-bill.  The FDIC's percentage of coverage is so small that they'd need to go hat in hand to the Treasury for help in a big crisis.  In that situation, I could see the government guaranteeing these FDIC accounts but freezing them until things settled down.

Having said that, I do keep a small-ish slice of my cash in FDIC-insured instruments.

[TripleB]

In my mind, it's safe to keep up to 10% of your cash in a tax-free muni MMF. That would be 2.5% of your overall portfolio.

As stated above, the price of the bonds, and thus the yield, is already pricing in the tax deferment. However, if you are borderline on having some deductions phased out, it might be worthwhile to reduce your AGI by using a tax-exempt MMF.

Personally I hate paying taxes, so if I get to a point where I have maxed out my 401k, IRA, EE/I Bonds, and annuity up to the limit of the state specific insurance fund, and assuming I already maxed out with as many "tax-exempt" gold coins held personally and still maintain a 25x4 HBPP, and assuming I already have most of my stock allocation in taxable brokerages, then I would consider putting up to 10% of my cash allocation into TE-MMFs.

That said, I'd have to triple my salary to reach that point, so I will probably never invest in TE-MMF, but I do allow myself to do it.

[KevinW]

Wouldn't the feds just print more money to make their FDIC guarantee good?

Probably, in the same way that they "just" raise the debt ceiling whenever that comes up.  There's an ugly game of brinkmanship, a "no" result is conceivable, there is much wailing and gnashing of teeth, and everyone with money on the line has to white-knuckle it until a decision is made at the 11th hour.