What are Tax-Exempt Money Market Funds

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Tax-exempt money market funds invest only in short-term municipal securities. These are issued by local governments and government agencies to raise money for their operations.

Tax Exempt Money Funds Can Come From These Local Governments:

City governments

County governments

State governments

School systems

Public hospitals

Public stadiums

There're over 50,000 local government agencies that issue municipal bonds.

They Issue Short-Term Securities, Municipal Notes (or Munis), that Money Market Funds Specialize In:

Tax Anticipation Notes (TAN)

Revenue Anticipation Notes (RAN)

Tax and Revenue Anticipation Notes (TRAN)

Bond Anticipation Notes (BAN)

Variable Rate Demand Bonds -- Lower Floaters

(These are long-term tax-exempt muni bonds converted by a dealer into a short-term security.)

To encourage investors to buy these local-government securities, the federal government exempts the income you receive from federal taxation.

Before you decide that not paying taxes is a "no brainer" and rush to put your money into a tax exempt market fund, you must understand that because of their (federal) tax-free status, these securities pay less interest than equivalent notes issued by businesses. Therefore, the dividend yield from these funds is less than the yield of general purpose funds.

To figure out whether it's better for you to park your money in a tax-exempt fund or a general purpose fund, first find out what your marginal tax rate is.

Then you must calculate the equivalent yield. Then you compare the equivalent yield of the tax-exempt fund to the actual yield of the taxable general purpose fund, and put your money in the one that pays the most.

Tax-Exempt Equivalence Equation:

Taxable equivalent yield = tax-free yield/(1 - tax rate)

For example, if you're in the lowest tax bracket of 10% and you're evaluating a tax-exempt fund that pays 2% --

Taxable equivalent yield = .02/(1 - .10)

Taxable equivalent yield = .02/.90

Taxable equivalent yield = 0.022222%

Therefore, if you can find a taxable fund that pays more than 2.22%, you're better off putting your money into that fund and just paying the taxes.

The Higher Your Tax Rate, the More Money a Tax Exempt Fund Would Save

If the two yields are almost the same, it's a toss-up. Go with whichever money fund is most convenient to you. Remember that the yields of both funds will change in the future, due to changes in the prevailing interest rates in the country. Plus, it's likely that in the future your tax rate will change due to changes in your income level or changes in the tax laws.

If you live in certain high-tax states, it may be worthwhile for you to find a tax-exempt money market fund that invests only in municipal securities issued within your state. This means that you not only do not pay federal income tax, you won't pay state income taxes either. So if you're in California, New York or some other high-tax state, check that out. Those of you living in Florida, Nevada or any state with no or low taxes, be grateful.

What are the advantages of mutual money market fund accounts

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