Positives & Negatives of Money Market Accounts
Money market fund accounts serve as popular alternatives to bank savings accounts, cash holdings and other low-interest demand deposits. Featuring a high level of liquidity and frequent payments of interest, money market accounts confuse many investors, who think of them as nearly identical to bank savings accounts. They are not. There are some very important differences between money market accounts and similar investment alternatives.
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Rate of Return versus Demand Deposits
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Money market accounts pool the assets of numerous depositors and invest the proceeds, creating a investment fund typically holding high-quality, high-liquidity short-term securities. Very often, the rate of return on money market funds will exceed that of demand deposit accounts, such as savings accounts, offered by banks and other financial institutions. The difference in return, however, especially in a low-interest-rate environment, is typically very narrow. In addition, the return on money market funds fluctuates considerably -- albeit typically within a narrow range.
Rate of Return versus Longer-Term Investments
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Although the rate of return on money market funds typically exceeds that of demand deposits, such as savings accounts, it still trails the long-term expected return on most other investments. Although dependent on the interest-rate environment, the majority of financial institution certificate of deposit (CD) accounts tend to produce higher returns. In addition, the long-term expected return for nearly all stocks and bonds greatly exceeds that of money market funds. Stocks and bonds are significantly more volatile, however, and are usually not suitable for short-term investment purposes.
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Insurance
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The Federal Deposit Insurance Corporation (FDIC) provides insurance protection for qualified deposit accounts at member banks of up to $250,000 per depositor, per insured bank. This deposit insurance is available for savings accounts but is not available for money market funds. Money market funds, however, have historically had an extremely low default risk and some funds will acquire third-party insurance, although the scope of this insurance may be limited, and it will typically not guarantee the full return of the investor's principal.
Liquidity
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Many investors prefer money market funds because of the high level of liquidity. Money market funds typically allow investors to add or withdraw funds without restriction. Many other short-term alternative investments, such as CDs, may charge investors a substantial penalty for early withdraw. In addition, money market funds typically do not charge transaction fees for the purchase and withdraw of shares.
Taxation
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In the United States, the proceeds of money market funds are typically taxed to individual income taxpayers at full, ordinary income tax rates. In addition, as distributions from a money market fund are typically computed daily, there is no deferral of income available for a long-term holding period in a fund. Many other investments, such as stocks, bonds, and longer-term mutual funds, will allow investors the benefit of income deferral and special reduced tax rates on all or a portion of their investment.
Warning
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Money market fund accounts should not be confused with money market deposit accounts. Money market deposit accounts are demand deposit accounts issued by banks and other financial institutions to compete with money market fund accounts. Money market deposit accounts do not invest in money market instruments and will generally feature a lower rate of return than money market fund accounts.
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