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While the earnings from some money market funds have tax advantages, others do not. Normally the highest interest rates are paid by general purpose funds that invest in corporate bonds (also called commercial paper) and negotiable "jumbo" certificates of deposit of $100,000 or more issued by banks.
Government bond funds are more conservative, investing in non-tax exempt government bonds. Typically these pay lower interest rates than general purpose funds but carry less risk. Either general purpose or government bond money market funds are actually a very safe investment because providers pledge to maintain the value of investors' shares in the fund and only rarely has a fund proved unable to keep this commitment. - Many government bonds are exempt from some taxes. These bonds pay lower rates than other bonds but the tax exemptions can more than offset the difference, especially if you are in a high tax bracket. Some money market funds invest in T-Bills and other federal short-term bonds. The interest paid by these bonds is exempt from state and local taxes. Another type of tax-exempt fund invests in state and local bonds that are exempt from federal income taxes.
- Another way of categorizing types of money market funds is by provider. Most banks (and credit unions) either have or partner with money market funds to offer accounts to their customers. Deposits are insured by the FDIC or National Credit Union Authority, just as are other consumer bank accounts. Financial investment companies such as Charles Schwab Funds, Fidelity Investments and Vanguard Funds also have money market funds. As a general rule, these pay higher interest rates although they are not insured by the government. The funds with the best rates tend to have high minimum balance requirements that can be as much as $25,000.
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Money market funds are low risk but not zero risk. There are two points to be aware of: interest rate risk and risk to principal. Money market rates follow prevailing interest rates closely owing to the rapid turnover of the short-term securities they hold. If interest rates fall, money market rates follow.
Non-insured money markets do sometimes fail to maintain their $1 per share par value. For example, in 2008 in the wake of the Lehman Brothers collapse, Reserve Primary shares fell to 97 cents. Still, despite the extraordinary economic events at the time, most funds held their par value. This event should serve to remind investors that the safety of money market funds is a relative thing, not a guarantee.
