Money market funds contain short-term notes, government bonds or other debt, which comes due in a short time, normally 30 days or less. Because of the short period to maturation, the notes or bonds seldom fluctuate in price. Fund advisers can only purchase high-quality bonds for the funds, and since the maturation is short, the fund managers also know the bond or note issuer won't default on the loan. There are taxable money market funds and tax-free funds. The tax-free funds hold tax-free bonds or notes issued by state and local governments or their agencies.
Interest on a municipal money market fund is lower than the interest on a taxable money market. The federal and sometimes state tax-free status of the fund makers the investment more attractive to the investor and saves the municipalities thousands of dollars in interest, which is the purpose of the tax preferential treatment. This also saves you tax dollars.
Check Your Tax Bracket
While not paying taxes on interest might sound alluring, you need to make certain you make more when you consider your tax bracket. Sometimes a taxable interest rate is better if you aren't in a high tax bracket. To compare rates, you add any state tax to your federal tax bracket and change that number to a decimal. Then add one to that number and multiply it times the non-taxable rate. This is the return you'd have to get for the same taxable interest. If you have a taxable account, subtract the decimal from one and multiply it times the taxable return to find the non-tax equivalent rate.
In a perfect world, the rate for tax-free funds would be the same as their taxable cousins when you consider tax-brackets. However, by now you know the world's not perfect and rates don't always compare. If you do the math and find the taxable account is better, even when you consider taxation, no matter how high your tax-bracket, taxable is better. It's all about what you get to keep in your pocket, not about taxes or no taxes. Sometimes, even though the tax-free is better for in the highest tax-bracket, taxable is better for everyone else.
Consider Phase Out of Standard Deductions and Exemptions
In 2009, people with higher incomes lose their personal exemptions and standard deductions when their taxable adjusted gross income reaches a specified amount. Married filing jointly start losing the standard deduction and exemption as their income increases beyond $250,200 until the deductions and exemptions disappear when it reaches $372,700. Single people begin to lose their exemptions and standard deductions at $208,500 and they phase out completely at $331,000. Head of the household filers start losing at $166,800 until it's entirely gone at $289,300 and married filing singles phase out starts at $125,100 and completely phases out at $186,350 in 2009. If your income is just over the income at which the deductions and exemptions phase out and it's due to taxable interest, go with the non-taxed funds. While Congress repealed the limits for 2010 taxes, most experts expect them back in 2011.