Tax Exempt Money Market Funds: VMSXX

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When I compiled a list of high yield savings accounts rates, a reader mentioned that tax exempt money market funds blow all those returns out of the water. He was totally right. In fact, I have a portion of our savings invested (I say invested because your principal is not protected by FDIC insurance in a money market fund) in Vanguard’s Tax Exempt Money Market Fund (VMSXX [Google Finance: VMSXX]).

About Tax Exempt Money Market Funds

The Vanguard’s Tax Exempt Money Market, and in general all tax exempt money market funds, seeks to maintain the $1 share price while generating a return using very safe assets. Specifically, they invest in “short-term, high-quality municipal securities issued by state and local governments across the United States.” That’s how they can guarantee that the earnings are exempt from federal personal income tax. With VMSXX, they invest in securities that are a year or shorter and a dollar weighted average of 37 days (as of this writing). You’ll find that most funds are structured this way regardless of the company. I am using Vanguard as an example because I have my money there.

Calculate Taxable Equivalent Yields

Since the yield is exempt from taxes, it’s not fair to compare them to other investments without some additional math to account for the tax exempt status. The easiest way is to find out which marginal tax bracket you’re in and divide the yield by (1 – marginal tax bracket).

If I’m in the 25% tax bracket and I want to find the taxable equivalent yield of an asset with a yield of 4%, I divide 4.0 by 0.75 = 5.33%. A tax exempt security yielding 4.0% is the equivalent of a taxable security yielding 5.33%. That 25% tax really takes a big chunk out of that return, huh? That’s why tax exempt securities are so attractive.

You can use this simple tax equivalent yield calculator to help you do the math.

Not FDIC Insured, Other Points

Some things to keep in mind about money market funds:

  • They are not FDIC insured, so they are investments. However, I believe that tax exempt funds are safer because they are investing in munis; rather than corporate bonds. When those money market funds broke the buck a few weeks ago, it was because they were invested in Lehman corporate bonds. While those were considered safe too, a company is far different from a state or local government. That being said, state and local governments can also go bankrupt, it’s just less likely.
  • Much like savings accounts, these fund yields aren’t guaranteed. With an dollar averaged holding period of 37 days, the yields can fluctuate very rapidly and much more so than the yield on a savings account.
  • Don’t invest in tax exempt securities in tax-advantaged accounts like a Roth IRA. Since the earnings in a Roth IRA are already tax free, it makes no sense to put it in a tax exempt investment. You take the teeth out of what makes the investment attractive in the first place.

If you want to get another opinion, Nickel also put some money in VMSXX and wrote about his experiences with the tax exempt money market funds.

{ 7 comments, please add your thoughts now! }

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7 Responses to “Tax Exempt Money Market Funds: VMSXX”

  1. Eric N. says:

    Hi Jim,

    I’ve been reading a lot about these tax-exempt MMFs lately, but is it true that their great yields are an abnormality because of market conditions? I’m just curious about what is considered their “normal” yields and if they do in general outpace online savings account.

    Also, thanks for the last point about not investing in them in accounts like Roth IRAs. For some reason, that didn’t click in my head initially….so the best way to invest in these are through taxable investment accounts right?

    Thanks for the post!

  2. jim says:

    Hmmm, they may be high right now because of market conditions (they are high, as to why it’s unclear) but they’re still high. 🙂 I don’t really know what normal is but I do know that in the past, when I have looked at them, they were OK yields (not great, but not bad).

    Yep, the best way is in taxable investment accounts.

  3. Flexo says:

    I invested in VNJXX (New Jersey Tax-Exempt Money Market Fund, exempt from federal income taxes and my state income taxes) at the beginning of the month (and wrote about it, naturally). On Oct. the 7-day yield was 4.83%, now it’s 2.82%. A result of everyone jumping into tax-exempt money market funds? Or a new lack of faith in the state’s economy? I don’t know, but it turned out to be not as great a move as I thought.

  4. Miss M says:

    I just started investing in a tax free bond fund, not quite the same thing but similar. It’s free from both federal and California state taxes. I haven’t tried it long enough to have an opinion, I’ve been meaning to add a bond fund for awhile. I wouldn’t be surprised if everyone is jumping on these right now, any investment that is in positive territory is better than the current alternatives.

  5. Patrick says:

    I have heard of State Money Market funds where you don’t pay federal or state taxes. Right now they are pretty nice to have, but if the market rebounds, they are only good to own if you pay very high taxes. I wish I would have put all my money into one last year though…

  6. Chris Pavoni says:

    Curious as to how safe Vanguard’s California tax-exempt money market fund will be if The state of California continues its downward budgetary spiral and is unable to meet its debt obligations. Cities in California ie. Vallejo going bankrupt and other cities following suit. We are protected until April ’09 if this fund ‘breaks the buck”, but it is the ensuing months after that worries me.

  7. Liz says:

    If I invest $5000 in a money market account, will I get paid interest every month and if so, how much? Also, is there any penalties for withdrawing the funds if I need them? What’s the current interest percentage right now?

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