A money market account is a specific type of bank account that often pays higher interest rates than other bank products. You generally must pay tax on the interest you receive from a money market account. Some brokerages also offer similar funds called money market funds, and you generally must pay tax on dividends paid by those funds as you earn them unless they're held in a tax-deferred retirement account.
How Money Market Accounts Work
A money market account is a specific type of account offered by some banks. It generally has some features of a savings account and some features of a checking account and pays a higher rate of interest than other accounts. You can often write checks and potentially even use a debit card with a money market account, but the number of withdrawals you make per month can be limited.
The name comes from the fact that funds you deposit are usually invested in short-term debt, which is traded on markets known as the money markets. Money markets generally refer to markets for loans due in a year or less, while capital markets refer to markets for longer-term debt.
Like other bank accounts in the United States, money market accounts at banks are insured by the Federal Deposit Insurance Corporation up to $250,000 per depositor and institution. Money market funds, which are mutual funds available through brokerages, are not insured, though they are considered relatively low-risk investments.
Money Market Withdrawal Rules
One of the significant differences between a money market account and a traditional checking account is that you are generally limited to six withdrawals per month or statement cycle. This is also true of many traditional savings accounts.
You sometimes can make more withdrawals in person or at an ATM than you are allowed to make by check or debit card. Contact your bank for information about what's possible with an account you're considering and make sure you understand the rules before signing up for an account.
Money Market Account Taxes
Money market tax considerations and savings account tax considerations are generally relatively simple. These accounts pay interest, which is taxable as ordinary income when you file and pay taxes. Like other income, the amount you pay depends on your income tax bracket and any credits or deductions you might have to offset some of your income.
Your bank will generally send you Internal Revenue Service Form 1099-INT if you earned at least $10 in interest and will send another copy to the IRS. You should receive this form in the early part of the year. File it with your paper tax return or include the information on your digital return. You may wish to compare the numbers against your records, such as bank statements, to make sure it's accurate.
Money Market Funds
Money market funds are often used as a way to stash funds and earn a bit of money relatively safely in a brokerage account. The funds invest in low-risk, short-term loans and distribute the proceeds to investors as dividends. They're designed to maintain an asset value of $1 per share.
People sometimes use money market funds to effectively store money in an investment account in between longer-term investments.
If the fund drops below this value, it's known as breaking the buck. That only happens rarely, and regulators will normally force the fund to liquidate if it does happen, usually getting investors back the bulk of their money.
Taxes on Money Market Funds
Money market funds pay out earnings as dividends. Dividends are generally taxable as ordinary income in the year they're received. If you have a fund or security with an arrangement to reinvest dividends back into the security, you usually still must pay tax on the dividends you receive. Some securities pay what are called qualified dividends, which are taxed at the lower capital gains rate rather than the ordinary income rate, but that usually doesn't apply to money market funds.
If you receive dividends in a given tax year, you will usually receive IRS Form 1099-DIV. If you receive one, file it with your taxes or enter the data on your digital tax return. Consult your financial institution with any question about the form.
Understanding Retirement Accounts
Generally, you pay tax on income for the year you receive it. Certain exceptions apply for retirement accounts such as 401(k) employer-sponsored plans and individual retirement arrangements or IRAs.
If you hold a money market account in such a fund, you generally won't be taxed on the dividends until you withdraw money from the retirement account. IRAs and 401(k)s enable you to invest money and defer paying taxes on it until you retire when you are often in a lower tax bracket than when you work. You can reallocate money between funds within a retirement account or receive dividends or interest within the account without paying tax on it until you withdraw it.
If you withdraw money from a retirement account before age 59 1/2, you will usually owe an additional tax penalty of 10 percent unless certain exceptions apply.
How Roth IRAs Work
A specialized type of retirement account is called a Roth IRA. With a Roth IRA, you pay tax as normal on money you earn while you are working and invest it in the account, where it effectively grows tax-free. When you reach retirement age, you can withdraw money without paying any additional tax.
Money market funds are often available as investment options within Roth IRAs and other types of IRAs, though many investors prefer to invest in riskier investments with higher earning potentials, such as stocks and stock funds.
No matter what investment options you choose, you won't owe tax on your Roth IRA earnings provided you wait to withdraw them until age 59 1/2. Otherwise, you'll usually be required to pay tax on them plus an additional 10-percent penalty.
IRA Withdrawal Penalty Exemptions
You can take withdrawals from an IRA without penalty under certain special circumstances, even if you're younger than 59 1/2, though you'll usually still owe taxes on the amount you withdraw.
You can take these withdrawals if you're called up for active duty from the National Guard or military reserves or if you are unemployed and need to pay for health insurance for yourself and your family. If you're buying your first home, you can withdraw up to $10,000 without a penalty for related expenses.
Certain higher-education expenses and medical expenses above 7.5 percent of your IRS adjusted gross income can also be paid for with IRA money without incurring a tax penalty.
Remember that withdrawing money from your IRA for such purposes means less money will be available to use if and when you do retire.
2018 Tax Law Changes
As of the tax year 2018, ordinary income tax rates are decreasing for many taxpayers. Standard deductions are also increasing. On the other hand, some federal tax deductions for things like employee expenses and state and local tax are being eliminated or capped.
The lower tax rates will likely mean many taxpayers will end up paying less in money market account taxes in 2018 than compared to prior tax years.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.