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When I compiled a list of high yield savings accounts rates ^[3], 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 ^[4] [Google Finance: VMSXX ^[5]]).

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 ^[6] 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 ^[7] 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 ^[8].