Would Tax-Free Money Market Funds Give You a Better Return?

As April approaches, can income tax anguish be far behind? Every year it's the same. You work hard, live frugally, save your money, and invest it carefully. Then, when the fruit of your labor and sacrifice—your interest check—arrives, state and federal governments step in and demand their cut. Their combined share (for most families) starts at about one-third and can climb to almost one-half of your investment earnings. Obviously, any investment which can avoid such a heavy penalty is worth knowing about.

We regularly list several tax-free money funds in our Sound Mind Investing newsletter. These funds invest solely in the IOUs of state and local governments which will mature, on average, sometime within the next year. These bonds were originally issued in order to raise money for the construction of public projects like roads, schools, and hospitals, and now the time is close at hand when they will be repaid in full. They are called municipal bonds (or "munis") because of the governmental units which issue them.

By law, the interest earned on such bonds is exempt from federal income taxes. Furthermore, if the issuer happens to be (1) the state in which you're a legal resident, or (2) is a municipality within your state, the interest is exempt from state income taxes as well. Because of the value of these tax benefits to investors, issuers of tax-free bonds can borrow money at lower interest rates than those paid by other borrowers.

Even though their yields are lower than regular money market funds, you might be better off investing in the tax-free kind. Use the formula explained in the box below to convert the yield of any tax-free fund to its equivalent before-tax yield. Then you can compare apples with apples. (Due to a provision in the tax code which affects the deductibility of itemized deductions, tax-frees are even more attractive than the formula would imply if your adjusted gross income rises above the $150,500 area.) All you need to know is your "marginal" tax rate. At present, the federal tax law provides for six basic tax rates (10%, 15%, 25%, 28%, 33%, and 35%). How high up the tax ladder does your income take you? That's your marginal rate.

 

 

Tax-free money funds offer the same liquidity and other advantages as their taxable counterparts, but there are a few additional considerations that make their risk slightly higher. For one, there is a default risk on muni securities where there is virtually no such risk for other money market securities like Treasuries and bank CDs. Another is that, due to the limited number of muni securities available at any one time, tax-free money funds have occasionally had to extend their average maturities or lower their quality standards in order to acquire the dollar amounts needed. Having said this, however, the increased level of risk is quite small due to the diversification you get when buying shares in a large money fund portfolio.

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Originally published March 28, 2007.