How to Earn More Than 3% on Your Savings as a Student Loan Borrower

You might think I’m about to drop an obvious line like “paying off your debt is the best savings rate you can get.” With so many of our readers going for student loan forgiveness plans, this advice would be totally irrelevant. In fact, there’s a way to get over 3% on your savings that’s unique to student loan borrowers going for forgiveness.

Perhaps you’ve heard of municipal bonds. I used to trade them for a living prior to founding Student Loan Planner. This kind of investment is generally tax-free, meaning you owe no federal income tax on the interest income you get from a muni bond.

While you might have heard of municipal bonds, you probably haven’t heard of municipal money market funds. This kind of investment could add hundreds or even thousands of dollars a year in interest income to your bottom line while you’re working towards forgiveness on your student loans.

What are municipal money market funds?

A money market fund in general is made up of super short-term, bond-type investments. These don’t fluctuate much in value, which allows the investment company to always list the value of the fund as $1.00. That means your savings only go up and aren’t subject to market fluctuation.

The money can also be pulled out at any time within 24 hours and transferred to your checking account (it might take a couple business days for ACH transfer, though).

A money market fund might invest in corporate and U.S. government debt. If you put it in retirement, you don’t have to pay income taxes on the interest.

However, if you hold it outside retirement accounts, you have to pay taxes on the interest income at your marginal tax rate.

For example, pretend you earn $450,000 as a couple and you invest in the Vanguard Prime Money Market Fund and earn 2.4%. You have to pay 35% in income tax on the 2.4%, so your after-tax earnings on the fund are only 1.56%.

In contrast, a municipal money market fund is invested in tax-exempt securities. This means you don’t have to pay income tax on the interest.

VMSXX, Vanguard’s national municipal money market fund, is one example. You could earn 1.81% in this fund as I write this article, but the income is exempt from federal taxes.

How student loan borrowers get hit hard with taxes on savings accounts

Remember, when you make payments on your loans under Pay As You Earn (PAYE) or Revised Pay As You Earn (REPAYE), the government takes 10% of your Adjusted Gross Income (AGI) — minus a small deduction.

Tax-exempt interest doesn’t show up on your AGI. However, interest from savings accounts does.

So, pretend that couple earning $450,000 per year combined was a pair of dentists in California going for PAYE 20-year loan forgiveness.

Their actual tax rate for every additional dollar earned would be 35% + 10% for PAYE + 9.3% California = 54.3%. Seems like that tax rate would be more appropriate for billionaire hedge fund managers!

Assume they found a high-yield 2% savings account. After paying taxes on their interest, they’d actually only get to keep 0.914%.

How a municipal money market fund could offer a 3.54% tax-equivalent yield

Tax-equivalent yield means taking the after-tax yield and converting it into a yield before income taxes get taken out so you can compare two accounts apples to apples.

For example, you can invest in state-specific municipal money market funds and get tax exemption from state income taxes, too. Vanguard offers the California Municipal Money Market Fund, which yields 1.62% as I write this.

What would be the tax-equivalent yield on this income? Remember, the interest is tax-free for federal and state income taxes. This is because all the investments in this fund are tax-free California paper.

You’d take 1.62% and divide by 1 minus the marginal tax rate of the couple or individual.

We said that rate was 54.3% for the $450k dentist couple. So, to figure out what 1.62% tax-free interest feels like if it were a savings account, you’d take 1.62% / (1 – 0.543) = 3.54%.

That means our dentist couple pursuing loan forgiveness could earn a 3.54% tax-equivalent yield on their savings if they used a California municipal money market fund at Vanguard instead of their local bank.

What are the risks of municipal money market funds?

Savings accounts with banks have FDIC insurance. Municipal money markets (or any money market) does not have this insurance.

Technically, you could lose money in this type of investment, even though you’ll never see the dollar value of your holdings go down because of the fixed $1.00 share price.

I would advise my grandma to put her most important life savings in a money market fund without hesitation, but you have to make your own decision.

Money market funds as an asset class were essentially protected by the Federal Reserve in the last financial crisis. If they survived without losses in 2008, there’s very minimal risk here.

I think municipal money markets are excellent places to park savings. I suggest keeping two months’ worth of expenses in checking and the rest in some sort of high-yield savings account.

 What income should you make to invest in municipal money market funds?

I think for student loan borrowers, any AGI above $157,500 as an individual or $315,000 as a couple would put you into the 32% marginal bracket. If you’re also pursuing loan forgiveness, that’s another 10% in tax savings from using the pretax muni money markets.

So anyone earning above those income levels could effectively earn over 3% in tax-equivalent yield by using Vanguard’s national muni money market fund, VMSXX.

Don’t forget to check out state-specific municipal money market funds

Here’s a list of state specific municipal money market funds Vanguard offers:

• New York Municipal Money Market (VYFXX)
• California Municipal Money Market (VCTXX)
• New Jersey Municipal Money Market (VNJXX)
• Pennsylvania Municipal Money Market (VPTXX)

If you don’t see your state listed, you can always use the national muni money market fund VMSXX.

The only one I’d be a bit cautious about using is the New Jersey muni money market fund. The management team is excellent; it’s the state credit I worry about since their pension is so badly underfunded.

You’d likely have so much advance notice that you’d have nothing to worry about if you were invested in a state-specific fund that had problems. That’s because the average maturity of the investments is ultra short term, so there’s very minimal risk.

Fidelity offers state-specific money market funds for Michigan, Ohio, Massachusetts and Arizona, too.

You should be able to buy funds from many different fund families in a brokerage account with most investment companies.

That gives you tons of options to avoid paying more taxes than you need to.

3% yields are possible for student loan borrowers

Investing your savings in municipal money market funds is one of my favorite hacks for high-income student loan borrowers pursuing forgiveness.

The Trump tax cuts made state tax-exempt investments even more valuable. But when you’re losing 10% of your AGI too, you need every loophole in the book.

Municipal money market funds are a very high-probability chance at getting over 3% tax-equivalent yields. The best part is you don’t need any sketchy gimmicks to get it.

These kind of original ideas are what we think up every day to help student loan borrowers with high balances. Check out our student loan planning service or our investing course to see how we could help you learn more.