What is a Tax-Exempt Money Market Fund?

A tax-exempt money market fund is a conservative mutual fund containing debt securities that pay interest that is not taxable. Interest received from government issued bonds is often tax-exempt if the person holding the bond lives in the state or nation that issued the bonds. In the United States, interest from bonds issued by state and local governments is generally exempt from federal income tax.

Money market funds invest in short-term and low-risk debt securities, such as commercial paper and government bonds. Investors use money market funds as an alternative bank accounts, although like all mutual funds, money market funds have no principal guarantees. Share prices of money market funds have a par value, and the share price seldom deviates from this value. Investors receive dividend payments on the shares, which consist of interest payments derived from the underlying assets. Yields on money market funds are usually low and are comparable with rates paid on bank savings accounts.

People who are in high tax brackets can lower their tax burden by investing in a tax-exempt money market. The yield paid on a tax-exempt money market is usually less than the rate received from a taxable money market, but the elimination of taxable interest means that many taxpayers end up with a larger net gain by investing in tax-exempt funds. Investors who are in lower tax brackets do not benefit from owning tax-exempt money market funds.

Mutual funds are not insured, which means investors can lose money if the fund performs poorly. When a government defaults on bond payments the value of the impacted bonds decreases, and if a government files for bankruptcy, a bond can lose value altogether. Tax-exempt money market funds are less risky than individual bonds because the failure of any one bond issuer to honor its debts cannot cause the entire fund to become worthless. Ratings agencies assign credit ratings to all bond funds, but since all money market mutual funds contain very conservative investments, most funds receive similar ratings.

Some investors confuse money market mutual funds with money market savings accounts. Money market savings accounts are bank issued products that work similarly to regular savings accounts, although most have higher minimum balance requirements and pay better interest rates. In the United States, bank money market accounts are federally insured, which makes the accounts an attractive alternative to money market mutual funds. Money market accounts in other countries often take the form of fixed term deposits rather than savings accounts, and not all national governments insure these and other types of bank accounts.