There are two basic types of money market funds, taxable and tax-free. Taxable money market funds can be further broken down into different categories, including:
- General-purpose funds that are available to all investors directly from sponsoring mutual fund companies
- Stockbroker-affiliated general-purpose funds, also available to all investors, but which are often provided as part of a broader spectrum of broker services
- Special-purpose funds that are organized for individuals who have a particular affiliation, such as customers of a certain bank or special interest group
Money market funds versus money market deposit accounts
The main difference between money market funds and money market deposit accounts is that money market funds are not insured or guaranteed by the FDIC or any other government agency. Although money market funds seek to preserve the value of your investment at a constant value of $1 per share, it is possible to lose money in a money market fund. However, some money market funds may have arranged for private insurance. Because insurance always comes at a cost, insured accounts generally offer lower yields than uninsured funds.
Caution: Changing regulations have allowed some banks to offer their own mutual fund products, including money market funds. Although offered by banks, these funds are not FDIC-insured. When opening a money market account through a bank, be clear about whether you are establishing a money market deposit account or money market mutual fund.
Taxable money market funds
The yield on money market funds generally falls somewhere between those of FDIC-insured money market deposit accounts or short-term certificates of deposit (CDs), and those offered by longer-term CDs, which generally offer higher returns in exchange for tying up your money for periods in excess of one year.
Some money market funds invest exclusively in government money market investments, such as Treasury bills (T-bills) and other obligations of the U.S. government or its agencies. Because these conservative funds hold only instruments backed by the full faith and credit of the United States, their yields are likely to be lower than other funds that may invest in securities regarded as higher risk, such as commercial paper (issued by corporations) and Eurodollar certificates of deposit (which involve risks associated with foreign investing, such as currency fluctuations).
Yields on money market funds vary over time, and some funds may pay a higher rate than others either because they are designed to take higher risks or because they charge lower fees. You should review these policies and fee structures as they are described in each fund’s prospectus to determine a fund’s true yield over time.
Tax planning for mutual funds requires you to know that earnings from money market funds occur in three ways: interest and dividend distributions, capital gain distributions, and profits from selling fund shares.
Tax-free money market funds
Tax-free money market funds invest primarily in short-term obligations of tax-exempt entities, such as state and municipal authorities. The interest on these instruments is not subject to federal income tax, but may be subject to state and/or local income taxes. For certain investors, a portion of that interest may be subject to the alternative minimum tax.
Generally, income generated from U.S. Treasuries is exempt from state income tax. (Note that the tax-exempt benefit generated by U.S. government agency obligations, such as Ginnie Maes, usually does not pass through to shareholders).
There are also state-specific tax-free money market funds that concentrate in short-term securities issued within a particular state, providing residents of that state with income that is exempt from state and local taxes as well as federal tax.
Some tax-free funds diversify their investments throughout the United States and U.S. territories, such as Puerto Rico and Guam. Since some states have higher credit ratings than others, interest rates vary on these funds. A geographically diversified portfolio of municipal securities spreads out risks among states with varying credit strength.
Caution: Any capital gain distribution from a tax-free money market fund will generally be subject to tax, as will any capital gain that results from the sale or exchange of the fund shares.
Caution: Tax-exempt income from a tax-free money market fund is generally included when calculating modified adjusted gross income (MAGI) for purposes of determining the taxable portion of any Social Security retirement benefits.
Caution: A money market fund may advertise that it invests in government or municipal securities. However, this does not mean that the income you would receive is tax-free. Check the fund’s prospectus to determine whether income will be taxable or tax-free.
Taxable versus tax-free money market funds
Depending on your tax bracket, you may find that your returns are actually better with tax-free investments, even though they pay a lower rate, because on an after-tax basis you get to keep more of the money you earn. To choose the right one, you need to compare the tax-equivalent yields of both funds.
Compare the yield of a tax-free fund to the after-tax yield of a taxable fund. To determine after-tax yield, multiply the rate of return by 100 percent minus your tax rate:
Pretax return X (100% – tax rate) = after-tax rate of return
For example: Assume you are in the 25% tax bracket and you earn a pretax return of 10%.
10% x (1 -.25) =.075 or 7.5% after-tax rate of return