CDs vs. Treasury Bills vs. Money Markets: Why New Yorkers Should Compare After-State-Tax Yield

Many retirees moved cash into certificates of deposit, money-market funds, and Treasury bills when short-term yields rose. What surprises people is the tax bill that follows — and, for New York City residents especially, that two cash vehicles with the same stated yield can leave very different amounts after taxes.

This article is educational and general. It does not recommend any specific bank, fund, or security; the right place to hold cash depends on your bracket, liquidity needs, and insurance preferences.

How is interest taxed at each level?

Interest from a bank CD, a savings account, or a typical money-market fund is ordinary income. It is taxed by the federal government at your marginal rate (IRS Topic 403), by New York State under its ordinary-income brackets, which range from 4% to 10.9% depending on income and filing status (NYS Department of Taxation and Finance), and — for residents of the five boroughs, including Staten Island — by New York City at rates generally between 3.078% and 3.876% (NYC Department of Finance).

Interest on U.S. Treasury bills, notes, and bonds is different. It is fully taxable at the federal level but exempt from state and local income tax, including the "interest" on a Treasury bill, which is the difference between what you pay and the face value at maturity (TreasuryDirect). On the New York return, that interest is subtracted on Form IT-201, line 28 (IT-201 instructions), which removes it from both the state and the city calculation.

Interest on New York State and municipal bonds is generally exempt at all three levels for a New York resident, while interest on other states' municipal bonds is exempt federally but added back on the New York return (IT-201, line 20).

Why does the state and city layer matter so much here?

In a low bracket, or in a state with no income tax, the difference between a CD and a Treasury bill of the same yield is small. For a New York City resident in a higher state bracket plus the city tax, the combined state-and-local rate on CD interest can approach the mid-teens — and removing that layer is the equivalent of a noticeably higher pre-tax yield.

A hypothetical, for the method only: suppose an investor faces a 24% federal rate, a 6% state rate, and a 3.8% city rate. On CD interest, roughly 34% goes to taxes; on Treasury interest, roughly 24%. The Treasury bill could yield about 13% less than the CD and still leave the same after-tax amount. Your own rates will differ; run the comparison with them.

Do Treasury money-market funds get the same treatment?

Often, but not automatically. New York allows the subtraction for a fund's dividends only if the fund meets a 50% asset requirement each quarter, and only for the portion derived from federal obligations (IT-201 instructions, line 28). Fund companies publish this percentage each January. A "government" money-market fund holding mostly repurchase agreements rather than Treasuries may pass through far less of the exemption than its name suggests, so check the fund's own tax-information report.

What else does interest income affect?

Interest doesn't just raise your tax bill directly. Because it is included in adjusted gross income, it can:

• Increase the share of your Social Security benefits that is taxable. Benefits become partly taxable once "provisional income" — which includes all interest, even tax-exempt municipal interest — exceeds $25,000 for a single filer or $32,000 for a joint return (IRS Publication 915).
• Push you toward the 3.8% Net Investment Income Tax, which applies above $200,000 of modified AGI for single filers and $250,000 for joint filers (IRS Topic 559). Treasury interest is exempt from state tax but is not exempt from NIIT.
• Raise your Medicare premiums two years later, because Part B and Part D income-related surcharges are based on the tax return from two years prior (Social Security Administration).

The state exemption on Treasury interest does not help with any of these three; only the state and city income-tax layers are affected.

How should a New Yorker compare cash options?

Compare what each vehicle leaves after all the taxes that apply to you — federal, state, and, in the five boroughs, city — rather than stated yields. Then weigh the non-tax differences: FDIC insurance on deposits versus the full-faith-and-credit backing of Treasuries, CD early-withdrawal penalties versus the ability to sell a bill before maturity, and a floating fund yield versus a locked CD rate. None is "better" in the abstract. Together with your withdrawal plan and the rest of your New York tax picture, they determine where cash is most efficiently held.

The bottom line

In most of the country, the tax difference between a CD and a Treasury bill is a footnote. In New York City, it is not. Treasury interest skips the state and city income-tax layers while CD and most money-market interest does not, so a New York resident should compare cash yields only after all taxes. Check the state-exempt percentage on any government fund you hold, remember that interest still counts for Social Security taxation, NIIT, and Medicare premiums, and confirm the numbers with your tax preparer before moving money.

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