Treasury bills instead of savings accounts

In short

A friend of mine kept $20,000 in a savings account for three years and never once asked what it was earning. If you are holding cash you will not touch for a while, it is worth knowing that the Treasury sells its own short term IOUs, called Treasury bills. You can buy them straight from the government at TreasuryDirect.gov, with no broker needed. Interest on them is exempt from state and local income tax, though federal tax still applies. Compare the Treasury bill rate at auction with the rate your bank pays, and then look at your state tax rate. A bill is not a bank account, so know how you will get your money back before you buy anything. This guide explains how the whole thing works and what it costs, and it does not tell anyone what to buy.

The whole of it

What it is

I once watched my neighbor sell a calf at the county fair, and he told me the buyer paid less than the calf was worth because the buyer had to wait to be paid back. That is the idea behind a Treasury bill, only the buyer is you and the seller is the United States government.

A Treasury bill is a loan you make to the federal government for a short time. The terms run from a few weeks up to a year. The Treasury Department sells them at a discount to their face value, and when the bill matures, the government pays the full face value. The gap between the two is your interest. There is no coupon and no monthly check. You pay less now and get paid more later.

A savings account works differently, and the difference is worth saying plainly. A bank holds your deposit, and the bank sets the rate. The FDIC, which is the Federal Deposit Insurance Corporation, insures deposits up to a limit set by law, currently the current figure, which the official source publishes each year. A Treasury bill is not a deposit and has no FDIC insurance. It is backed by the full faith and credit of the United States government instead. Two kinds of safety, then, and they are not the same thing.

How it works

If you are thinking of trying this, the process is simpler than most folks expect. You can open an account at TreasuryDirect.gov, which is the Treasury's own website, and buy bills there. You can also buy them through a brokerage account, though a broker may charge fees or pay you differently, so ask before you start.

The Treasury sells bills at auction on a regular schedule. Most buyers place what is called a noncompetitive bid, which means they accept whatever rate the auction sets. The price you pay is the face value minus the discount. If a bill has a face value of $1,000 and sells for $985, you pay $985 and get $1,000 at maturity. The $15 difference is your interest.

When the bill matures, the Treasury pays you the face value. At TreasuryDirect, the money goes to the bank account you linked. You can also set the bill to roll over, so the Treasury buys a new one for you with the proceeds. That is handy, but it also means you must check each time that the new rate still suits you.

One more thing about timing. You can sell a bill before it matures, but at TreasuryDirect that takes extra steps, and a broker handles it differently. The price you get then depends on the market that day. If you might need the cash on short notice, that matters a great deal.

The numbers, and where to find yours

Your own situation sets the real numbers, so here is where to look. The current auction rates are posted on the Treasury's site, TreasuryDirect.gov, under its auction information. Your savings account rate is on your bank's website or your statement. Put them side by side.

Then think about taxes, because that is where bills can pull ahead. Interest on Treasury bills is subject to federal income tax. It is exempt from state and local income tax, which the Treasury says on its own site. If you live in a state with an income tax, that exemption can make a bill's after tax return better than the headline rate suggests. If your state has no income tax, you get no extra benefit there.

Your federal tax bracket matters too. The IRS publishes the brackets each year, currently the current figure, which the official source publishes each year. Your state's tax agency posts your state rate. To compare fairly, work out what each option leaves you after tax, and not just what it pays before tax.

Also check the FDIC limit I mentioned, the current figure, which the official source publishes each year, if you are weighing safety. A balance above that limit at one bank has more risk in a savings account than the same money in Treasury bills.

A worked example

Let me tell you about a woman named Ruth, who lives in a state with a 5 percent income tax. She has $20,000 she will not need for six months. Her savings account pays 4.0 percent a year. A six month Treasury bill is selling at a discount that works out to 4.3 percent a year. Her federal tax rate is 22 percent.

First, her savings account. Six months is half a year, so her interest is $20,000 times 4.0 percent times one half. That is $20,000 times 0.04 times 0.5, which equals $400. Federal tax at 22 percent is $400 times 0.22, or $88. State tax at 5 percent is $400 times 0.05, or $20. She keeps $400 minus $88 minus $20, which is $292.

Next, the bill. Her interest is $20,000 times 4.3 percent times one half. That is $20,000 times 0.043 times 0.5, which equals $430. Federal tax at 22 percent is $430 times 0.22, or $94.60. State tax is nothing, because the bill is exempt. She keeps $430 minus $94.60, which is $335.40.

The difference is $335.40 minus $292, or $43.40 over six months. Not a fortune. Still, it is real money for doing a little homework.

Now look at how fragile that picture is. Suppose Ruth lived in a state with no income tax. Her savings account would leave her $400 minus $88, or $312. Her bill would leave her $430 minus $94.60, or $335.40. The gap shrinks to $23.40. And if her bank paid 4.3 percent too, the bill would have no edge at all. The numbers decide it, and Ruth should run her own.

Where it goes wrong

I have seen smart people trip over a few things here, and none of them are about being foolish. They are just easy to miss.

The first is liquidity, a plain word for how fast you can turn something into cash. A savings account lets you withdraw any day. A bill pays you at maturity, and selling early can mean a lower price. If an emergency might hit before the bill matures, that bill is the wrong tool for that money.

The second is rollover surprise. If you set a bill to renew on its own, the Treasury buys the next one at whatever the rate is then. Rates can drop. You might not notice for months.

The third is taxes on the other side. The discount counts as interest income, and you owe federal tax on it. The Treasury sends a Form 1099 INT for interest earned, and the tax is due for the year the bill matures, not the year you bought it. A person who forgets this gets an ugly April.

The fourth is the comparison trap. The auction rate and a savings account rate are quoted in slightly different ways, so a quick glance can mislead. Use the actual dollars, as Ruth did, and the picture gets clear.

Last, account access. A TreasuryDirect account requires a linked bank account and a bit of patience with the website. If you lose your login, the Treasury has a process to recover it, and it takes time. Plan for that.

Questions to answer before you leave this page

When will you actually need this money, and could that date move up without warning? What does your savings account pay today, and what does the latest auction on TreasuryDirect.gov say a bill of the same length pays? Does your state tax interest income, and if so, at what rate according to your state tax agency? What is your federal bracket, and how much would each choice leave you after tax in real dollars? Will you buy at TreasuryDirect or through a broker, and what would each way cost you? Have you decided whether to let a bill roll over, or to take the cash and decide again? And if the answer to any of these is a shrug, are you willing to sit with it a little longer before you move a single dollar?