Definition of a Tax-Free Money Market Fund

A money market fund is a mutual fund which holds investments considered to be cash equivalents, such as bonds, instead of holding shares of stock. These include short-term government bonds and rapidly maturing bonds issued by companies with very strong credit profiles. Money market funds are meant to be a safe place to park cash for easy access while still earning a return. They are usually managed to have a fixed share value of $1 so you can essentially take out the same money that you put in, plus interest. However, unlike bank accounts, the share value isn't guaranteed.

A tax-free fund places an additional layer of requirements on top of the money market fund. It only buys securities that pay interest exempt from taxes, usually municipal bonds. The federal government doesn't charge tax on municipal bond interest, which allows local governments to pay lower interest rates. Since the fund owns those tax-free bonds, the interest that it pays is also tax-free.

Tax-exempt money market funds come in different types. Some only hold bonds exempt from the alternative minimum tax (AMT) as well as the regular income tax. This is necessary because the AMT taxes certain types of municipal bonds, called private activity bonds, but excludes others from taxation. Other funds might only own bonds from a particular state because some states tax bonds from other states but not those they issue. If you live in Florida, for instance, you might choose to buy a tax-free money market that only buys bonds that originated there so you won't have to pay any state tax.

Before rushing out and buying a tax-free money market fund, you might want to compare the return to what you would earn on a taxable fund. For instance, given a choice between a taxable fund paying 1.3 percent and a tax-free fund paying 1 percent, you might do better to take the taxable fund if you pay tax in the 15 percent bracket since you'd give up 15 percent of your interest in taxes and still end up with a 1.105 percent yield. If you pay taxes in the 28 percent bracket, though, you'd get 0.936 percent from the taxable fund after paying taxes and 1 percent from the tax-free fund, making the latter the better investment.