Many investors use both taxable and tax-exempt money market funds to hold cash for short periods of time. Some very conservative investors use money markets as an alternative to bank-issued certificates of deposit when interest rates are very low. As the name implies, earnings from tax-exempt funds are not federally taxed, whereas distributions from other funds are subject to both state and federal taxation.
Tax-exempt money market funds contain municipal bonds issued by state and local government entities across the U.S. The federal government does not tax interest payments derived from these funds. The funds use the interest payments to fund dividends, which are therefore not federally taxable. The funds are also free from state tax if the underlying assets are bonds issued by the state in which the shareholder lives. Taxable money market funds contain short-term certificates of deposit, federally issued bonds and commercial paper. Both funds invest in short-term instruments, which reduces the likelihood of major price fluctuations.
Differences in Yield
The yields or dividends received by people who own shares in taxable money market funds are usually higher larger than those received by investors holding tax-exempt funds. The taxable funds have to compensate for the effects of taxation and can compete with tax-exempt funds only by offering better returns. However, since returns on both funds are driven by the yields of the underlying investments, on occasion tax-exempt funds' yields are very similar to yields on taxable funds. When this occurs, many investors flock to the tax-exempt funds to maximize their earnings.
Levels of Risk
There are two main types of municipal bonds: general obligation bonds and revenue bonds. Local and state governments pay interest on the former, while revenue from projects such as toll roads pays the interest on the latter. Funds holding the bonds lose value if payments are late or defaulted upon. Generally, revenue bonds are riskier than general obligation bonds.
Some people believe taxable money market funds pose less risk than tax-exempt funds because they think it's less likely that the federal government will default on bonds, compared with state governments. However, there are no guarantees, and taxable funds also contain CDs that rely on the financial strength of the issuing entity.
People often confuse both money market fund types with money market accounts, which are offered through banks and credit unions. Money market accounts are not investment products but are instead a type of savings account. Money invested in bank-issued money market accounts is insured by the Federal Deposit Insurance Corp. Neither taxable nor tax-exempt money market funds are insured by the federal government. Money market savings accounts are similar to money market funds in that the accounts pay modest yields and are intended for short-term investing.