Choosing a Money Market Fund

Have you ever wondered whether you would be better off using a tax-exempt money market fund rather than a taxable fund? Here is a practical tip on how to make the right decision.

Most full-service and discount brokerage houses, including the on-line trading firms, offer money market sweep accounts. With these accounts, you park your spare cash in a money market fund and collect interest until you decide what to do with the money. You can use your money market assets to invest in stocks, bonds or mutual funds at your convenience. The better programs also offer free unlimited checking and electronic bill-paying.

When you invest in a money market fund, the interest you earn is taxable at your marginal state and federal tax rates. This can result in a substantial tax liability, particularly if you're in a high income bracket. One solution is to choose a tax-exempt money market. These funds typically invest in municipal bonds thereby avoiding federal taxes. Depending on your state of residence, you may be able to steer clear of state and local taxes as well. The only downside to the tax-exempt money market accounts is that they pay lower interest rates than the taxable accounts.

How do you decide which one is best for you? Fortunately, there is a simple formula for comparing taxable and tax-exempt money markets. Just plug the tax-exempt interest rate into this formula:

Equivalent taxable interest rate = (tax-exempt interest rate)/(1 - your tax rate)

As an example, let's assume that you are opening a brokerage account at TD Waterhouse. You can either choose the standard (taxable) money market fund, which pays 5.86%, or the tax-exempt municipal fund, which pays 3.75%. In order to make the two interest rates comparable you simply plug the tax-exempt rate into the formula:

Equivalent taxable interest rate = 3.75%/(1 - 0.396) = 6.21%

As you can see, you would be better off in the tax-exempt fund. Notice that we've assumed the maximum 39.6% tax rate. Investors in lower tax brackets are often better off in taxable money market accounts. Be sure to use your correct marginal tax rate when doing this calculation. If you're not sure of your tax bracket, you should be able to get it with a quick call to your accountant.

July 1, 2000

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