The Investor's New Loophole: Why Treasury Bills are Crushing HYSA for US Tax-Free Gains

Are you a tax-aware American investor looking for the safest place to park your cash without losing value to inflation? If your savings are sitting in a High-Yield Savings Account (HYSA), you are likely leaving thousands of dollars on the table for state and local tax authorities to claim. With top HYSAs currently offering Annual Percentage Yields (APYs) up to 5.00%, this option may seem like the best path for liquidity and return.

But for you, and millions of Americans, particularly those residing in high-tax states, that seemingly attractive APY is an illusion. The silent financial shift that is reorganizing short-term investment strategies is the realization that the tax code has created a massive investment loophole that makes a U.S. government debt instrument—the Treasury Bill (T-Bill)—the superior choice for maximizing your after-tax returns.

Well, you are an investor in a high-tax state like California (with a top marginal state income tax rate near 9.3%). A competitive HYSA offering a 4.40% APY actually delivers an after-tax return of approximately 2.93% when combined with a 24% federal bracket. By contrast, a 4-week Treasury Bill (T-Bill), with a yield of approximately 4.09%, delivers an after-tax return of 3.11%. In this common scenario, the lower-yielding T-Bill instantly becomes the superior choice for your net gain.

This slight-but-significant margin is the heart of the Tax-Free Gains Investment Loophole. While the gross yield of a Treasury Bills vs HYSA USA Tax is often neck-and-neck, the federal debt instrument carries a decisive, legally mandated tax advantage—it offers tax-free gains US Treasury Bills at the state and local level. This exemption is the invisible lever that allows T-Bills crushing high-yield savings accounts once your tax bill arrives.

The Taxable Trap of the High-Yield Savings Account

A High-Yield Savings Account alternative is needed because HYSA interest is treated as ordinary taxable fixed-income. This means every dollar you earn is subject to taxation at both the federal and state/local levels. This also applies to the interest portion of certain short-duration bonds and most traditional bank products. For those considering 5 Safe Alternatives to the Stock Market for Short-Term Cash, understanding the tax implications is valuable for your financial plan.

In states with no income tax, this isn't a major issue, but the United States includes residents of states with high income tax rates, such as New York, California, and Massachusetts. For these individuals, a 5.00% HYSA APY must be reduced by both a federal levy (which can exceed 30% depending on your bracket) and a state/local levy (which can exceed 10%). The result is a substantial drop in the true, usable return.

The HYSA is a liquid, FDIC-insured product, but its full taxability makes it less efficient for wealth preservation compared to its government-backed counterpart.

Decoding the T-Bill Tax Loophole: State and Local Tax Exemption

Treasury Bills are short-term government debt obligations (with maturities typically ranging from 4 to 52 weeks) that are sold at a discount to their face value. The comparison between Treasury Bills vs HYSA USA Tax hinges entirely on the interest earned. The return—the difference between the discounted purchase price and the face value paid at maturity—is the interest earned. For a thorough primer on all federal securities, see The Complete Guide to Understanding US Treasury Securities [Internal Link: The Complete Guide to Understanding US Treasury Securities].

The key tax advantage stems from the Constitutional immunity doctrine. As a debt instrument of the federal government, the interest earned on T-Bills is generally exempt from all state and local income taxes—a direct benefit to your pocket. The official stance is confirmed by the U.S. Treasury, which explicitly states that interest is exempt from state and local taxes, a foundational tax-planning tool you should use Source: Treasury Bills - TreasuryDirect.

• Federal Tax: T-Bill interest is subject to federal income tax (just like HYSA interest).
• State & Local Tax: T-Bill interest is fully exempt from state, county, and municipal income taxes (unlike HYSA interest).

This state and local tax exemption transforms the competitive landscape, making it a powerful investment loophole that allows you to legally shield a portion of your income from state tax authorities.

 The Crushing Formula: Understanding Tax Equivalent Yield (TEY)

To accurately compare a fully taxable HYSA to a state-tax-exempt T-Bill, you must use the Tax Equivalent Yield (TEY) calculation. This formula answers the question: What APY would a fully-taxable investment need to offer to match your after-tax return of the state-tax-exempt T-Bill?

We can prove how a T-Bill, despite a lower posted yield, often generates a superior after-tax return, thus justifying why T-Bills are crushing high-yield savings accounts.

Example:

• Investor Profile: US Resident in a state with a 9.3% marginal state income tax rate and a 24% marginal federal tax rate.
• T-Bill After-Federal Tax Return: 4.09% yield $\times$ (1 – 24% Federal Tax Rate) = 3.11% After-Tax Return (This is the cash you keep)
• Tax Equivalent Yield (TEY) Calculation:

TEY = {(T-Bill After) – (Federal Tax Yield)}/{(1 – (State Tax Rate)}

= 3.11%/(1 – 0.093)

= 3.11%/0.907

= 3.43%

This result means that the 4.09% T-Bill provides the same after-tax cash flow as a fully taxable investment (like a HYSA) yielding 3.43% APY.

The Tax-Free Gains Investment Loophole in High-Tax States

The TEY advantage only grows more dramatic in states with high marginal income tax rates. You should look up your state's top bracket to determine the full value of this exemption.

• New York (approx. 10.9% max rate): A T-Bill's tax advantage is significantly higher here than in California, as the state exemption shields an even larger percentage of your income.
• Massachusetts (approx. 5.0% flat rate): Even in a state with a flatter tax, you save 5.0% on every dollar of interest earned from a T-Bill, which is pure, immediate profit relative to a fully-taxable instrument.
• New Jersey (approx. 10.75% max rate): In a state with a rate this high, the spread between the taxable HYSA and the T-Bill widens considerably, making the T-Bill a functionally lower-risk, higher-yield asset after taxes are calculated.

Short-Term Investment Strategies: Safety, Liquidity, and Risk

Beyond the tax arbitrage, T-Bills offer two main features crucial for your short-term investment strategies and cash management: safety and liquidity. This provides a sophisticated answer to the Treasury Bills vs HYSA USA Tax dilemma. The yields of both T-Bills and competitive HYSAs are heavily influenced by the Federal Reserve's interest rate policy, making them responsive to current market conditions.

1.        Zero Default Risk: Treasury Bills carry the unconditional guarantee of the United States government. This makes them virtually the safest investment in the world, often considered lower risk than even FDIC-insured HYSAs in the event of an extraordinary market crisis.

2.     Liquidity and Interest Rate Risk: While you must hold a T-Bill until maturity (e.g., 4, 8, 13 weeks) to realize the full stated return, they are highly liquid and can be sold easily on the secondary bond market before maturity. However, you should be aware of the inherent interest rate risk: should prevailing market rates increase after you have bought your T-Bill, its secondary market value will decrease. This means selling before maturity could lead to a capital loss. This is a risk that money market funds (MMFs) and short-duration bonds also face.

Step-by-Step: How to Buy T-Bills for State Tax Avoidance

1.        Directly via TreasuryDirect: This is the government's official platform and the easiest way to ensure you avoid unnecessary fees. You purchase T-Bills directly at auction. At the end of the tax year, TreasuryDirect will automatically generate Form 1099-INT, which clearly separates the interest earned on U.S. government obligations, simplifying your state tax filing process.

2.     Through a Brokerage Account: Most major brokerage firms (like Fidelity or Vanguard) offer T-Bills. The benefit is convenience, as you can hold all your investments in one place. However, the brokerage's Form 1099-INT may not automatically segregate the U.S. government interest. You may need to reference supplementary statements or the firm's website to find the exact amount of U.S. Treasury income that is exempt from your state tax.

In the current environment where federal vs state taxation creates an unequal playing field, T-Bills are the clear winner for tax efficiency. They are not just an investment for institutional portfolios; they are a sophisticated short-term investment strategy you can immediately use for every tax-aware US investor.

FAQ on The Investor's New Loophole: Why Treasury Bills are Crushing HYSA for US Tax-Free Gains

Q1: Are Treasury Bills completely tax-free?

A: No. All earnings generated by Treasury Bills remain liable for federal income taxation. The main advantage is that the interest is exempt from all state and local income taxes, which results in significantly higher after-tax gains, especially for residents of high-tax states.

Q2: How does the risk of a T-Bill compare to an HYSA?

A: Both are considered extremely safe. A High-Yield Savings Account is protected by FDIC insurance up to $250,000. T-Bills carry the ultimate backing of the federal government, giving them essentially a zero default risk, regardless of the investment amount.

Q3: What is the Tax Equivalent Yield (TEY)?

A: The TEY is a metric used to compare the return of a tax-exempt investment (like a T-Bill) to a fully taxable investment (like a HYSA). It shows what a fully-taxable investment would need to yield to match the after-tax return of the tax-exempt investment, providing a clearer view of which option truly provides the most cash in your pocket.

Q4: Do I need a brokerage account to buy T-Bills?

A: No. You can buy new-issue T-Bills directly from the U.S. government using a TreasuryDirect account, which allows you to bypass brokerage fees. You can also purchase them through most major brokerage firms.

Q5: Do all states honor the T-Bill tax exemption?

A: Yes. The exemption of interest earned on U.S. government obligations from state and local income taxes is required by federal law and upheld in all 50 states.

Q6: What is the minimum investment for T-Bills?

A: The minimum purchase amount for Treasury Bills is $100. They are sold in increments of $100. This makes them highly accessible to small investors.

Q7: Are T-Bills affected by inflation?

A: The value of a T-Bill is not directly adjusted for inflation. Inflation can erode the purchasing power of your return, but T-Bills are a hedge against inflation risk when compared to traditional savings accounts, as their yield generally moves with the Federal Reserve's rate adjustments.

Q8: What is the difference between a T-Bill and a T-Bond?

A: The main difference is the maturity date. T-Bills are short-term securities (up to 52 weeks). T-Bonds are long-term securities with maturities of 20 or 30 years, and they pay interest every six months.

Q9: Is T-Bill capital gain/loss subject to state tax?

A: Yes. If you sell a T-Bill on the secondary market before maturity and realize a capital gain or loss, that gain or loss is typically subject to state and local capital gains taxes, as the exemption only applies to the interest income portion.

Q10: Can I use T-Bills for my emergency fund?

A: T-Bills are excellent for emergency funds because they are safe and highly liquid. However, you should align the T-Bill's maturity (e.g., 4-week or 8-week) with your need for cash. For cash needed immediately, an HYSA is often better.