After years of near-zero interest rates, cash is generating real yield again. Treasury bills and money market funds were paying between 4.2% and 4.5% through much of 2024 and into 2025. That is genuinely good news for investors holding liquid assets. What some families are discovering at tax time is that meaningful yield also means meaningful taxable income, and the structure of how that cash is held determines how much of the return they actually keep.
Why Interest Income Is a Bigger Tax Issue Than It Used to Be
For most of the decade following the 2008 financial crisis, interest rates were low enough that interest income was a negligible part of most portfolios. A family holding $500,000 in cash might have earned $2,500 to $5,000 annually, not worth restructuring anything around.
At 4.5%, that same $500,000 generates $22,500 in annual income. For a family in the 37% federal bracket plus state income tax, the after-tax yield drops materially depending on where and how the cash is held. The rules around what is taxable and at what level have not changed. What has changed is that following them now makes a meaningful difference.
What Is Taxable and What Is Not
The tax treatment of interest income varies significantly by instrument and account type. These distinctions have always existed, they are simply more relevant now that yields are substantial.
Money market mutual funds
Dividends from taxable money market funds are generally taxed as ordinary income at both the federal and state level. For high earners, this means the gross yield overstates the after-tax return by a meaningful amount. Government money market funds investing primarily in Treasury securities may pass through some state tax exemption, but this varies by fund and requires verification.
Treasury bills, notes, and bonds
Interest from Treasury securities is subject to federal income tax but exempt from state and local income tax. For investors in high-tax states (California, New York, New Jersey, and others with top rates above 9%) this exemption is significant. A 4.5% Treasury yield produces a higher after-tax return than a 4.5% taxable money market fund for most residents of high-tax states, sometimes by 40 to 50 basis points on an after-tax basis.
Municipal money market funds
Interest from municipal money market funds is typically exempt from federal income tax and may be exempt from state tax as well, depending on where the investor resides and where the underlying bonds were issued. The gross yield is lower than taxable alternatives, but the after-tax yield for investors in high federal and state brackets can be competitive or superior. The comparison requires knowing the investor's marginal rate.
Tax-advantaged accounts
Interest and dividends earned inside IRAs, Roth IRAs, and HSAs grow without current taxation. For investors holding meaningful cash positions, the account in which that cash sits determines whether the interest is taxed annually or deferred. This is the essence of asset location, placing the least tax-efficient assets in the most tax-advantaged accounts.
The Asset Location Question Most Families Have Not Revisited
Asset location refers to which assets are held in which account types. For many families, this question was settled years ago and has not been revisited since, which made sense when the tax difference between accounts was small.
At current yield levels, holding a taxable money market fund in a brokerage account versus an IRA can represent thousands of dollars of annual tax difference for a high-earning family. The decision of where to hold cash, not just how much to hold, has become a genuine planning question worth reviewing.
The practical approach is to compare after-tax yields across instruments given the family's actual marginal rates, then position cash in the account type where the tax treatment is most favorable relative to the household's full planning picture.
Additional Considerations for Complex Structures
For families using trusts, donor-advised funds, or multi-generational planning vehicles, the placement of interest-bearing assets adds another layer of consideration.
Income retained in certain types of trusts, particularly non-grantor trusts, may be taxed at compressed federal brackets that reach the top rate at relatively low income thresholds. Holding high-yielding cash in a trust that retains income can produce tax results that are worse than holding the same asset personally. This is worth reviewing with a tax advisor before assuming that a trust structure is automatically more efficient.
Assets held in charitable vehicles, including donor-advised funds, avoid annual taxation on growth and income. For families using these structures as part of a broader charitable giving strategy, directing interest-bearing assets through them can be part of a coordinated approach to managing taxable income.
What This Means for the Current Tax Season
Many high-earning families are receiving 1099s this year that reflect meaningful interest income for the first time in over a decade. For some, the numbers are surprising relative to how their investment activity felt during the year — because holding cash at 4.5% is not eventful, but the income it generates is real and taxable.
The most common planning conversation this is triggering involves three questions: Is the cash held in the most tax-efficient account type for this family's situation? Is the right instrument being used, particularly around the Treasury versus money market question for high-tax-state residents? And how does the interest income fit into the broader picture of estimated taxes, bracket management, and coordination with the CPA?
It is not just about what the cash earns. It is about where and how it is taxed.
Frequently Asked Questions
Is interest from Treasury bills taxable?
Treasury bill interest is subject to federal income tax but exempt from state and local income tax. This makes Treasuries particularly attractive for investors in high-tax states, where the state tax exemption can meaningfully improve after-tax yield relative to taxable money market funds paying a similar gross rate.
How is money market fund interest taxed?
Interest from taxable money market funds is generally taxed as ordinary income at both the federal and state level in the year it is earned. Government money market funds that invest primarily in Treasury and agency securities may pass through partial state tax exemption, but this varies by fund. Municipal money market funds may offer federal tax-exempt income and sometimes state tax exemption as well, depending on the fund's underlying holdings and the investor's state of residence.
What is asset location and why does it matter for interest income?
Asset location refers to the strategic placement of different assets across taxable, tax-deferred, and tax-exempt accounts to minimize the overall tax drag on a portfolio. For interest-bearing cash and fixed income, which generate ordinary income taxed at the highest rates, holding them in tax-advantaged accounts like IRAs or HSAs defers or eliminates that annual tax. At current yield levels, the difference between holding cash in a taxable brokerage account versus an IRA can represent thousands of dollars of annual tax savings for high-earning families.
How are high-yield cash positions taxed for trusts?
Non-grantor trusts reach the top federal income tax bracket at significantly lower income thresholds than individual taxpayers. Interest income retained in a non-grantor trust can be taxed at rates that are less favorable than if the same assets were held personally. Families using trust structures for wealth management or estate planning should review the tax efficiency of interest-bearing holdings within those trusts in collaboration with their tax advisor.
What is the difference between a taxable and tax-exempt money market fund?
A taxable money market fund invests in instruments whose interest is subject to federal and state income tax. A tax-exempt or municipal money market fund invests in municipal securities whose interest is generally exempt from federal income tax and may be exempt from state tax as well. The gross yield on tax-exempt funds is typically lower, but for investors in high federal and state brackets the after-tax yield may be equal to or better than taxable alternatives. The comparison requires calculating after-tax yield based on the investor's actual marginal rates.
Related Reading
- 5 Smart Year-End Tax Moves That Make a Difference (and 3 You Can Ignore)
- Year-End Tax Considerations for Business Owners (2025)
- Building Generational Wealth: A Simple Yet Powerful Strategy
- Private Credit, Regional Banks, and the Cost of Higher Rates
- The Gap That Shows Up in December
HWM Wealth provides financial planning and investment advisory services. This article is for informational purposes only and does not constitute financial, legal, or tax advice. Please consult a qualified tax professional for guidance specific to your situation.
