Cash, Treasuries, and California Municipal Bonds: Managing the Safe Side of a Portfolio

The conservative part of a portfolio deserves as much attention as the growth part, especially in a state with a 13.3% top income tax rate.

Equity compensation gets most of the attention in Silicon Valley, but every plan also needs a stable side: money for an emergency reserve, a home down payment, a tax bill due next April, or the bond allocation that steadies a retirement portfolio. How that money is held affects both its after-tax yield and its behavior when markets are stressed. For California residents, the choice among bank deposits, Treasury securities, and municipal bonds carries a distinctly local tax angle.

Bank deposits and money market funds

Checking, savings, and certificates of deposit are simple and, up to a limit, government-insured. The FDIC insures $250,000 per depositor, per insured bank, for each account ownership category. A household holding a large cash balance after a liquidity event can exceed that limit quickly, and may consider spreading deposits across institutions or ownership categories, or holding Treasury securities directly. Money market mutual funds are not FDIC-insured, though government money market funds are a common alternative. Interest from bank deposits and most money market funds is fully taxable at both federal and California rates, which for a high earner can consume more than 40% of the yield.

Treasury bills, notes, and bonds

Treasury securities are backed by the U.S. government and come in a range of maturities. Treasury bills mature in 4 to 52 weeks and are sold at a discount to face value, with the difference representing the investor's interest. Notes and bonds run from two to thirty years and pay interest twice a year.

The tax feature that matters most in California is that interest on U.S. Treasury obligations is subject to federal income tax but exempt from state and local income tax. California's Schedule CA instructions confirm that interest on Treasury bills, notes, and bonds is subtracted from federal income when computing state tax. For a resident in the 9.3% or higher state bracket, that exemption can make a Treasury bill more attractive than a bank certificate paying a similar headline rate. Treasury inflation-protected securities add a further feature: their principal adjusts with the consumer price index, and at maturity the holder receives the greater of the adjusted or original principal.

Treasuries are not without risk. Longer maturities lose market value when interest rates rise, as the SEC's bond primer explains, and inflation erodes the purchasing power of fixed interest payments. Short-term bills sidestep most rate risk but require reinvesting at whatever rate prevails when they mature.

California municipal bonds

Municipal bonds issued by states, cities, school districts, and agencies pay interest that is generally exempt from federal income tax. When the bond is issued within your own state, the interest may also be exempt from state tax. For a California resident, an in-state municipal bond can therefore be exempt from both federal and state income tax, a combination sometimes called double tax-exempt. Bonds from other states do not get this treatment; the Schedule CA instructions require adding non-California municipal interest back to state taxable income.

Consider a hypothetical: a taxpayer in the 37% federal bracket subject to the 3.8% net investment income tax and a 9.3% California rate faces a combined marginal rate near 50% on taxable interest. A fully taxable bond yielding 5% would leave roughly 2.5% after tax, so a California municipal bond yielding 3% could produce more after-tax income. The comparison depends entirely on the individual's bracket, and the arithmetic reverses for someone in a lower bracket or investing inside a tax-deferred account, where the exemption is wasted.

Municipal bonds carry credit risk, which varies widely among issuers, along with interest rate risk, call risk, and thinner trading than Treasuries. Some tax-exempt interest is also subject to the alternative minimum tax, a consideration for anyone already navigating AMT from an ISO exercise. Concentrating in one state's bonds also adds exposure to that state's economy and budget, a consideration for a household already dependent on California's tech economy.

Matching the tool to the job

• Money needed within a year, such as an estimated tax payment, is often held in insured deposits, a government money market fund, or Treasury bills.

• Money with a longer horizon may be spread across Treasury notes and municipal bonds, weighing after-tax yield against credit and rate risk.

• Bonds held in a 401(k) or IRA generally should be taxable ones, since the tax exemption of municipals provides no benefit there.

This article is educational only and does not constitute investment, tax, or legal advice; consider consulting a qualified professional about your own situation.

Important Disclosures

Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.