Ideally, the money you need should be easily accessible to you, for example bank and credit union savings accounts and money market accounts. These are liquid. You can turn them into dollar bills easily.
Mutual fund money market accounts are generally regarded as safe, but you should know that they are not federally insured. Most banks and credit unions are federally insured for deposits of up to $250,000.
There are both taxable and tax-exempt money market funds available. Your choice should depend on your marginal tax rate. Below is a chart to help you. It shows how a pre-tax return on an investment is reduced by taxes. If you take the after-tax return, you can compare it with yields on tax-free money market funds.
|
If your marginal tax rate is:
|
|
|
10%
|
15%
|
25%
|
28%
|
33%
|
35%
|
|
And your pre-tax
return is:
|
Then your after-tax return:
|
|
10%
|
9.00%
|
8.50%
|
7.50%
|
7.20%
|
6.70%
|
6.50%
|
|
9%
|
8.10%
|
7.65%
|
6.75%
|
6.48%
|
6.03%
|
5.85%
|
|
8%
|
7.20%
|
6.80%
|
6.00%
|
5.76%
|
5.36%
|
5.20%
|
|
7%
|
6.30%
|
5.95%
|
5.25%
|
5.04%
|
4.69%
|
4.55%
|
|
6%
|
5.40%
|
5.10%
|
4.50%
|
4.32%
|
4.02%
|
3.90%
|
|
5%
|
4.50%
|
4.25%
|
3.75%
|
3.60%
|
3.35%
|
3.25%
|
|
4%
|
3.60%
|
3.40%
|
3.00%
|
2.88%
|
2.68%
|
2.60%
|
For example, if your marginal federal tax rate is 25% and you are considering a taxable fund yielding 7%, your after-tax rate of return would only be 5.25%. If you can find a tax-exempt fund yielding more than 5.25%, you should consider it.
The previous chart works for comparisons with funds that are exempt from federal taxes. Some funds, however, are also exempt from state taxes. These funds must contain bonds from your resident state. If the investment is exempt from state income taxes as well, the following calculation factors in the state tax effect.
|
(A) Federal marginal income tax rate
|
25%
|
|
(B) State marginal income tax rate
|
6%
|
|
(C) Federal income tax benefit of state income tax deduction. Multiply (A) x (B)
|
1.50%
|
|
(D) Total federal and effective state income tax rate (A) + (B) - (C)
|
29.50%
|
|
(E) Subtract (D) from 100%
|
70.50%
|
|
(F) Taxable money market rate
|
5%
|
|
(G) Multiply (E) x (F)
|
3.53%
|
For a state marginal income tax rate of 6%, and a federal marginal income tax rate of 25%, a taxable money market rate of 5% is equivalent to a 3.53% state tax–free money market rate.
If you can do better than 3.53% on the state tax–free money market fund, go with it. If you can only get 3%, stay with the taxable fund.
If you look at the numbers carefully, you will see that the higher your tax bracket, the more sense tax-free funds make. If you aren't in the higher tax brackets, you should probably stick to taxable funds.
You may also wish to consider bank and credit union CDs. They are not as liquid because there's a penalty if you withdraw the money before maturity, but the extra interest they pay may be worth it. And they are also insured.
One way to deal with CD maturities is to ladder them. For example: You buy a one-year CD. Two months later, you buy another. Two months after that, another. If you buy six of these, you are never more than two months away from a maturing CD. You can do this with any length CD, in any combination that works for you.
