Tax-Exempt Money Market Fund

The tax benefits can be one of the primary reasons for investing in funds. An example of such funds that can offer tax benefits is the tax-exempt money market fund. It creates a type of income option that is appealing in its tax-free nature and, at the same time, retains qualities related to the safety and liquidity characteristics of money market funds. Regarding this, these funds are more appealing to high-net-worth investors or higher-bracket taxpayers seeking a short-term, low-risk investment with added tax-exempt advantages. 

In this blog, we will explain what a tax-exempt money market fund is, how it works, the different types available, and the related tax benefits. We will also give examples and cover some frequent questions that may help one learn whether this investment is appropriate for their portfolio. 

What is a Tax-Exempt Money Market Fund? 

A tax-exempt money market fund is a kind of mutual fund that invests in very short-term, high-quality securities of government entities or municipalities whose income is usually from federal income taxes. These funds offer investors a safe and liquid investment. 

Unlike other ordinary money market funds, which gain interest income subject to taxation, the income acquired by tax-exempt money market funds does not include federal taxes. Sometimes, depending on the investor’s state of residence and the type of securities in which the fund invests, income may also be exempt from state and local taxes. 

Tax-exempt money market funds are among the most attractive instruments available for significantly improving after-tax return in the eyes of many higher-bracket investors. 

Understanding Tax-Exempt Money Market Fund 

In general, a tax-exempt money market fund is defined by three basic essentials: safety, liquidity, and tax efficiency. 

Safety-the brand of tax-exempt money market funds. These funds generally would invest in high-quality, short-term securities like municipal bonds and government agency debt. The securities are usually backed by the issuing municipality or government entity and are considered relatively low-risk investments. Thus, they would be an excellent choice for a conservative investor who wants to preserve capital with at least a modest return. 

Liquidity: Tax-exempt money market funds are highly liquid; investors can redeem shares at any time. Hence, they are the most flexible investments if an investor needs his or her capital urgently, without penalties or delayed wait periods. 

Tax efficiency: This income from the tax-exempt money market funds does not bear any liability for federal income taxation. In addition, in some instances, this may be exempted from all state and local taxes, depending on the nature of the investment. Overall, the combination of safety, liquidity, and tax efficiency makes these funds quite an attractive choice for risk-averse investors in search of a tax-efficient, stable source of income. 

Types of Tax-Exempt Money Market Fund 

There are many types of tax-exempt money market funds, each with different levels of tax benefits and suiting various investment needs. 

1. National Tax-Exempt Money Market Funds

These funds invest in securities that are exempt from federal income tax withholdings. Interest income also does not come under federal taxation, although it can be taxed at the state and local levels. These are normally the most common kinds of tax-exempt money market funds. 

2. State-Specific Tax-Exempt Money Market Funds

State-specific tax-exempt money market funds invest in securities issued by municipalities or government agencies in a specific state. In addition to being exempt from federal income tax, the interest from these funds is also exempt from state and/or local taxes for state residents who hold the funds. These funds attract investors who reside in states with high tax rates. 

3. Municipal Tax-Exempt Money Market Funds

These funds invest in municipal securities and bonds issued by local governments and state entities. Interest income from municipal securities is normally exempt from federal taxes and, in some instances, state and local taxes as well. 

Benefits of Tax-Exempt Money Market Fund 

Tax-exempt money market funds attract several thousand because they will be able to generate income without the imposition of taxes, especially the heavier ones at the federal level. Let us take a closer look at the tax advantages these funds offer. 

1. Federal Tax Exemption

Tax-exempt money market funds generate most of their interest income without the encumbrances of federal taxes. This fact makes them far more attractive to those in higher tax brackets, where the after-tax return can be duly improved over that of taxable money market funds.

2. State and Local Tax Exemption

In addition to the federal tax exemption, numerous state-specific and/or local municipal money market funds grant exemptions from state and sometimes even local taxes. In many states, in this instance, the investor secures the benefit of both federal and state tax exemptions when investing in a California-specific tax-exempt money market fund. 

3. Higher Returns After Taxes

Even though tax-exempt money market fund yields might be a little lower than those that are taxable, tax savings can make the overall return more appealing. These tax benefits can translate into huge boosts to after-tax yield in the portfolios of high-net-worth investors, and for that reason, such funds rank among their favourites.

Examples of Tax-Exempt Money Market Fund 

1: National Tax-Exempt Fund 

A national tax-exempt money market fund invests in a variety of municipal bonds from all over the United States. The interest income generated from these bonds is exempt from federal taxes. For example, an investor falling in a high tax bracket would find the tax-free income generated by this fund more appealing than taxable funds offering better yields.  

2: State-Specific Tax-Exempt Fund 

For example, a California tax-exempt money market fund invests in municipal bonds issued by local governments in California. Its exempt status from federal and state taxes makes it a good avenue for California-resident investors. 

Frequently Asked Questions