A money market account is a collection of short-term investments. They are designed to be short-term accounts that hold your money until you have decided what to invest in for the long term. But these accounts also earn interest. You must understand the tax implications of money market accounts before investing in them, since they could increase your tax liability.
There are two types of money market accounts. The first is an ordinary money market account. These accounts are set up through banks, insurance companies and other financial institutions. Money is deposited into the money market to earn interest. The other type of money market is a qualified money market account. These accounts are held inside of an individual retirement account (IRA) or some other qualified retirement plan.
The benefit of a money market inside of a qualified retirement plan is that you do not pay income tax on the interest earned in the account. Like all investments inside of a qualified retirement plan, taxes are deferred until you withdraw money from the account.
The disadvantage to money markets is that, if they are not held inside of an IRA or some other qualified retirement account, the interest is fully taxable in the year the interest is earned. Interest is taxable as ordinary income.
Before investing in a money market account, consider that the money in the account should not be held here for long periods of time. Money markets are comprised of investments lasting one year or less. Because of this, the money market pays a very low rate of return. Often, this rate of return trails the rate of inflation. Consider investing in other investments that pay fixed rates of return if you are looking for safety, like bank CDs or fixed annuity contracts.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004