Tax Exempt Money Market Funds

Tax-free, or tax-exempt, money funds offer investors the advantage of earning income that is exempt from federal and, in some cases, state taxes.  For those investors in higher tax brackets, the after-tax advantage of these funds can be quite significant.  Tax-free funds invest in short-term obligations of tax-exempt entities, such as state and municipal authorities.  These money market funds pay daily dividends that are exempt from federal income taxes.  Some of these funds also provide returns that are free of state and local taxes as well.  Tax-exempt money funds generally pay lower yields than taxable money funds.  An investor who is in the 28 percent tax bracket or above, check to see if the lower yields on tax-free funds will generate higher after-tax returns for you than taxable funds.

Assets in taxable money market funds are measurably larger than those held in tax-exempt funds.  In part, this may be due to the relative scarcity of tax-exempt funds and the fact that investors often keep money market funds for short periods of time before deploying those assets elsewhere.  Because of their distinctive investment strategy, tax-exempt funds appeal to a different group of investors than taxable money market mutual funds and have experienced a different pattern of growth.  Otherwise, they generally have the same features and operating characteristics as other money market mutual funds.

Tax-exempt money funds generally pay lower yields than taxable money funds.  If you are in the 28 percent tax bracket or above, check to see if the lower yields on tax-free funds will generate higher after-tax returns for you than taxable funds.  To help you evaluate a tax-exempt money market fund, you may want to look at its taxable equivalent yield.  Taxable-equivalent yield calculates the yield you would have to earn on a taxable investment that would match the yield you earn on a tax-exempt fund.  For those investors in higher tax brackets, the after-tax advantage of these funds can be quite significant.

A significant development in the types of money market accounts promoted in recent years has been the proliferation of tax-exempt money market funds that buy only securities issued by governments within a particular state.  Such funds offer investors from those states interest income exempt from federal, state, and, sometimes, local income taxes.  State-specific tax-exempt funds have proliferated mainly in states with high tax rates and large populations.  The high tax rate stimulates the demand for the state’s securities by in-state residents, while the large population provides a market big enough for the MMF sponsor.  The most tax-exempt MMFs are found in California and New York, two states with high tax rates and large populations, but states such as Arizona, California, Connecticut, Florida, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Ohio, Pennsylvania and Virginia also have the option of investing in money funds that are free of federal, state and even local income taxes.

To calculate whether you should be in a tax-free fund, the following equation can be utilized: the taxable equivalent yield = tax free yield / 1 – the investor’s marginal federal tax rate.  The taxable-equivalent yield is roughly equal to the return you would receive from a taxable fund.  A tax-free investor should calculate the yield differences between tax-free and taxable funds to determine where he or she should invest.  For example, an investor in the 28 percent tax bracket could consider investing either in a tax-free fund, which may be paying 3.0 percent, or a taxable fund, which, let’s say, is yielding 5.0 percent.  Using this formula ( 3 divided by (0.72) ), the taxable-equivalent yield would be 4.17 percent.  In this case, the investor would be better off in the higher-yielding taxable money fund even after paying taxes.  For an investor in the 31 percent tax bracket, the taxable-equivalent yield would be 4.35 percent ( 3 divided by (0.69) ).  The investor, therefore, would also earn a better after-tax return by investing in the taxable fund.  An investor with a marginal tax rate greater than the break-even rate would earn a higher after-tax yield in a tax-exempt money fund than in a taxable money fund.

This entry was posted on Tuesday, January 6th, 2009 at 3:13 pm and is filed under Mutual Funds. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.