Money market mutual funds hold short-term financial instruments like U.S. Treasury bills, CDs, and the short-term debt of U.S. corporations, called commercial paper. The funds have a stated net asset value of $1.00 per share, and most offer check-writing privileges. They are instantly liquid. You don't have to wait for them to mature—you just write a check. The objective of a money market fund is to keep the value of a dollar constant while paying you some interest.
Money markets can be for:
- Emergency money
- Savings for short- and intermediate-term goals
- Providing diversity in the portfolio of a conservative investor
IMPORTANT NOTE: Although money market mutual funds are generally regarded as safe, they are not federally insured for deposits of up to $250,000 (limit until December 31, 2013 after which the limit will revert back to $100,000) like most bank deposits. If a fund makes poor choices regarding interest rates and the quality of securities it holds, there is a risk that the net asset value will go below $1.00, and you will lose principal. On the rare occasions that this has happened, the mutual fund parent usually added enough money to the fund to bring the asset value back up to $1.00. But this is not guaranteed.
There are three basic types of money market funds:
- Prime funds, which own commercial paper, CDs, and Eurodollar deposits. These are only as good and as safe as their underlying securities. Only buy funds owning the highest quality securities (AAA, Standard & Poor's; Aaa, Moody's).
- Government funds, which own either U.S. Treasuries or federal agency securities. The underlying securities carry the backing of the U.S. Government (not the fund itself), but the backing is "explicit" (stated) in the case of Treasuries, and "implicit" (assumed) in the case of agency bonds. You do not have to pay state taxes on the interest you receive.
- Tax-exempt funds, which hold either municipal bonds from all over the country (national) or from just one state. National funds are generally exempt from federal taxes. [If you are subject to the federal alternative minimum tax (AMT), a portion of the income may be subject to tax. The AMT is a federal tax aimed at insuring that a minimal level of income tax is paid, however the American Recovery and Reinvestment Act of 2009 (ARRA) repealed the AMT income inclusion for tax-exempt income from new private activity bonds issued in 2009 or 2010.] State funds are exempt from state taxes as well, if you live in the state. Look at funds containing the highest-grade issues with average rating by Moody's of at least MIG-1. Be aware that the 2009 ARRA also includes a taxable bond option, for local government bonds issued in 2009 and 2010 – so-called Build America Bonds – which includes a tax credit of 35% of interest payable to purchasers, instead of tax-exempt interest. Since the private investment market for tax credits may be limited for a time, the issuing authority of bonds issued in 2009 or 2010 may also receive a direct payment from the federal government equal to the tax credit.
IMPORTANT NOTE: When researching money market funds, you may notice that some funds have a yield (interest rate after expenses are subtracted) much higher than others holding the same kinds of securities. This is typically because the funds are either new or trying to attract more investors. Read the fine print! If the fund says that it is "temporarily absorbing operating expenses," then these higher yields are bound to go away.
You may be trying to decide on whether to choose a taxable or tax-exempt fund. See the section Liquidity Needs and refer to the "after-tax return chart" to help you. Take your federal marginal tax rate and the interest rate your taxable money market fund pays you. Follow the lines across and down to find your after-tax return. If you can do better than the after-tax return in a tax-exempt fund, use it. If not, stay in a taxable fund.
