To Tax or Not To Tax: That Is The Money Market Question

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As America’s love affair with self-investing continues to grow, so does our fascination with tax-free accounts. Don’t believe me? See for yourself. The next time you’re in a conversation, try working the words “tax free” into your conversation and watch the ears perk up. Admit it. We despise taxes. We loathe them. So much so in fact, that Uncle Sam made not paying those taxes a crime. So the idea that we can legally earn a buck without sharing it with our dear old uncle is well, deliciously criminal.

But as WiseBread investors know, what’s good and tax-free for one investor isn’t always the right choice for another and this holds true with all your investing venues, right down to choosing a money market fund.

Most money market funds are taxable and invest in things like Treasury Bonds and CD’s but there’s also a decent selection of tax-free funds that invest in the short-term obligations of tax-exempt entities such as your local government. While the yield from these tax-free investments are a bit lower than their taxable counterparts, any return you receive is typically exempt from our friendly Uncle Sam.

So which is better?

To determine the right investment for you, you need to take the tax issue out of the equation. Your taxable versus your tax-free as it were and luckily, there’s a pretty easy formula to help you make your decision.

Tax-free yield / (1.0 – your tax bracket) = Tax-free equivalent

So, let’s say we’re considering two funds: a taxable fund that pays 2.5% and a tax-free fund that pays 2.0%. If your tax bracket is 20%, your equation is going to look like this:

2.0 / (1.0-.20) = 2.5

In this instance, the tax-free equivalent is 2.5%, the same yield as your taxable fund. But lower the tax bracket to 15% and the results work out a little differently:

2.0 / (1.0 - .15) = 2.36%

That’s a .14% less return than the taxable fund. But what if you increase your tax bracket to 25%?

2.0 / (1.0-.25) = 2.67%

Now the tax-free fund is clearly the better choice, all other things (like expense ratios and investment selections) being equal.

Of course, neither of these investments will be your key to retiring early and realistically, a one-year CD is currently offering a higher return than MMF's. But that's not always the case and as we know, a good portfolio is one with some diversification.

The bottom line? Know how to get the most from your investing dollars which, after all is what smart investing is all about.