Money Market Accounts and Mutual Funds - Types of MMMFs

Part 2: Types of MMMFs

In Part 1 of Money Market Accounts and Mutual Funds we discussed the basics of money market accounts and money market mutual funds. Today we’ll examine the different kinds of money funds.

There are two general types of money market funds: taxable and tax-free. In a taxable money fund, any income that you earn is subject to federal, state and local taxation. Income from a tax-free fund is exempt from federal taxes, and may also be exempt from state and local taxation as well.

So, which type of fund is right for you? How do you know which one to choose? By comparing the returns from taxable and tax-free funds you’ll see that the tax-free generally return less. But that isn’t to say that they are of less value, because the fact that you pay no federal taxes increases the amount that you actually keep. You can calculate that amount, called the “comparative yield” or taxable equivalent yield, by dividing the tax-free yield of your investment by 100 minus your tax bracket. For example, if you’re in the twenty-eight percent bracket, you would divide by 72 (100 – 28 = 72).

Therefore, the higher your tax bracket the more of your return that you’ll have to pay in taxes, and the better the tax-free fund should begin looking to you. Taxable securities are generally better for most investors; if you’re in one of the higher brackets then the tax-free choice will probably be more advantageous. Don’t worry if you don’t feel confident enough to make the decision; any brokerage firm that sells tax-free funds will be able to do the calculations for you.

Some of the more specific types of money funds that can be invested in include:

General purpose funds, which invest in the broad range of short-term securities from highly-rated commercial paper to bank CDs. They are typically affiliated with the institution where you opened your account.

Government funds, whose yields are generally lower than those of general purpose funds because they do not carry as much risk. What they do carry is the backing of the federal government; they are, therefore, very safe investments. Some of these funds invest in only U.S. Treasuries; others invest in not only Treasuries but Ginnie Maes and Freddie Macs as well.

Federal tax-free funds, which invest in short-term municipal bonds from across the country. The income of these funds is exempt from federal taxes, but is subject to state and local taxes.

State tax-free funds, which invest in the municipal bonds of a single state. They’re also known as double- or triple-tax-frees: double- if free from federal and state taxes, and triple- if they’re exempt from federal, state, and local taxes.

Because of the SEC rule which requires the average maturity of all money fund portfolios to be under ninety days, the makeup of like funds generally tends to be about the same. As a result, the differences in return levels among funds can invariably be traced to one area; expense ratios. The lower the expenses associated with buying into the fund, the better that fund will perform over time. In other words, as long they are not too small and have reasonable track records, look for the funds that waive fees or keep expenses to a minimum.

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