Investors who poured cash into money market mutual funds in 2023 amid rising interest rates may be in for a surprise tax bill come April, according to experts. As of November 29, investors and institutions have funneled a staggering $5.84 trillion into these funds, with many offering attractive yields well above 5%.

The surge in investments into money market mutual funds is largely driven by fears in the stock market, as investors are seeking safer options with lower credit risk. However, the higher yields come with tax implications that may catch many off guard.

Certified financial planner Robert Schultz, senior partner at NWF Advisory Group in Encino, California, highlighted the significant tax implications of higher rates, stating, "With pennies earned in 2022 on cash assets, the tax bill was negligible. At 5% rates, there will be much higher bills, which will catch many off guard."

Money market funds differ from money market deposit accounts and typically invest in shorter-term, lower-credit-risk debt such as Treasury bills. These funds generally pay dividends monthly, and the earnings made during 2023 could be substantial. However, investors will owe regular income taxes on these earnings, with a top bracket of 37%, rather than the more favorable capital gains rates of 20%.

To put it into perspective, an investor in California with a combined state and local tax rate of 45% and $100,000 in a money market fund earning 5% could face a $2,250 tax bill, as per Schultz. It is worth noting that certain states may offer tax breaks depending on the underlying assets, such as money market funds with U.S. Treasury bonds, which may exclude a portion of earnings from state and local taxes.

One potential challenge for investors is that they may only become aware of their taxable money market earnings when they receive tax forms in early 2024. According to Schultz, this may feel like a late Christmas gift for many investors in February. Typically, investors receive tax forms for money market mutual funds in January or February, reporting the previous year's earnings to the IRS.

With interest rates on the rise and money market mutual funds witnessing record inflows, it is crucial for investors to be aware of the potential tax implications. Proper tax planning and understanding the tax treatment of different investment vehicles can help investors avoid any surprises when tax season arrives.