Tax Exempt Vs. Taxable Money Market Funds

A money market fund is a unique low-risk mutual fund that offers easy access to your money. You can think of it as a parking place for your investment dollars where they can be gainfully employed until you need them again. Money market funds are classified as taxable or tax-exempt, depending on the types of securities they invest in. Whether a taxable or tax-exempt fund is best for you depends on your tax bracket.

Money market mutual funds are regulated primarily by Rule 2a.7 of the Investment Company Act of 1940, which limits the kinds of investments these mutual funds can hold. Both taxable and tax-exempt funds are restricted to only investing in securities that are short-term, low-risk and highly rated, according to the Investment Company Institute.

Securities in taxable money market funds typically include short-term U.S. government notes, bank certificates of deposit, high-grade commercial paper from major U.S. corporations and collateralized repurchase agreements. Tax-exempt mutual funds typically hold short-term municipal securities from state and local governments. For regulatory purposes, securities that mature within 397 days are considered short-term.

Money market mutual funds attempt to maintain their net asset value at $1, and pay any earnings out in the the form of dividends, although they may occasionally also generate a capital gain. Since the securities held by taxable mutual funds pay taxable interest, all of the earnings these funds pass on to you are taxable. Tax-exempt funds typically generate income that is exempt from federal income taxes. Some funds invest in state-specific municipal securities, which exempts the income from state taxes as well, but any capital gains generated by a tax-exempt fund is taxable at the local, state and federal level.

Taxable money market funds typically produce a higher rate of return than tax-exempt funds, but if you are in a high tax bracket, you might get a better after-tax return on your money by investing in a tax-exempt fund. Money market funds are low-risk investments, but they are not risk-free. Unlike bank money market accounts, which are insured by the Federal Deposit Insurance Corporation, there is no federal insurance on money market funds, even if the securities held by the fund are guaranteed by the federal government.