Your ready cash will typically earn higher returns if you put it in a money market account rather than parking it in a traditional bank savings account. If you're willing to accept slightly greater risk, you can get a slightly higher interest rate by going with a money market mutual fund rather than a bank money market account. You'll have to pay taxes on the interest with either type of account, unless you opt for a tax-exempt money market fund.
Bank Money Market Accounts
Money market accounts are sometimes referred to as money market deposit accounts. You can think of a money market account as a hybrid of a savings and checking account. You get higher interest on your deposits than you typically receive on your savings, but you also get ready access to your money through checks or debit cards. Bank money market accounts are insured by the Federal Deposit Insurance Corporation, making them one of the safest of all investments. The interest you earn on your bank money market account is fully taxable at the local, state and federal level for the year in which you received it or once it is credited to your account and you have access to it.
Credit Union Money Market Accounts
Money market deposit accounts offered by credit unions operate in much the same way as bank money market accounts. Insurance for these accounts is provided by the National Credit Union Administration. Credit unions are member-owned organizations rather than corporations. Instead of paying interest on your money market account, your credit union pays dividends. The Internal Revenue Service taxes credit union dividends as if they were interest payments. Taxes are due on credit union money market dividends based on the year they are credited to your account and become available for withdrawal.
Money Market Funds
Money market mutual funds share a number of traits with money market deposit accounts, but they are two completely different investments. The most striking difference is safety. While money market mutual funds are limited by law to investing only in low-risk, short-term investments, they are not insured by the FDIC, NCUA or any other federal agency. Although rare, it is possible to lose money in a money market mutual fund. Money market mutual funds don't pay interest. They pay dividends. The IRS requires you to report money market fund dividends -- separately from your other interest income -- for the tax year in which they are paid.
Tax-Exempt Money Market Funds
Some money market mutual funds specialize in investing in securities that pay tax-exempt interest. They pass that tax-exempt income on to their shareholders. Some funds specialize even further by investing in state-specific tax-exempt securities, which provides dividend income that is exempt from both state and federal income taxes. You don't have to pay taxes on dividends from tax-exempt money market funds, although in some instances the fund might produce a taxable capital gain, which will be passed on to you.
Interest is taxable for the year in which it is constructively received -- that is, when it is paid to you or credited to an account and you can withdraw it. The payer should provide you with a Form 1099-INT or a Form 1099-DIV detailing how much you received. The IRS requires you to report and pay taxes on any interest you received during the year, regardless of whether you received a Form 1099.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.