Tax Exempt Money Funds: It's A Jungle Out There

You recently mailed your check to the Internal Revenue Service--and vowed to lower the stray interest income that swelled your bill from Uncle Sam. One way to do that is to sweep your cash from taxable interest-bearing accounts into a tax-exempt money-market fund.

Judging by the $93 billion that now fill them, these funds already are popular. And with rates on taxable money funds declining faster of late than their tax-free brethren, expect to see even more money pouring into the 250 or so such funds. Some pay interest that's free of U. S. taxes, but not state and local taxes, while others are exempt from all income taxes. With the variety of yields these funds pay, picking one can be tricky.

Even with the shrinking spread between taxable and tax-exempt funds, the tax-free route may not pay off unless you're in the top 31% bracket. State taxes are also important. Do you live in a state that levies no income tax, such as Texas? Or do you pay a steep state rate, as do New Yorkers and Californians?

Once you know where you stand, you can start looking for the right fund. The prospectus is key; among other things, it will disclose a fund's investment strategy. If the fund invests solely in U. S. Treasury bills, you'll owe tax only to the feds. If it buys notes of many states, you'll pay just a state tax.

Let's consider some cases. Say you live in Florida, where there's no state income tax, and you're in the top tax bracket. You might do best with a fund that invests in short-term municipals. The average yield of such funds now runs near 4.23%, equivalent to a taxable yield of 6.13%.

GREATER RISK. Now, suppose you live in the Golden State. There, a fund that invests solely in California issues would be exempt from California state and federal taxes. Recently, the highest-yielding such fund, General California Municipal Money Market Fund, paid 5.14%. A taxable fund would have to pay 8.21% to match that, and taxable yields now average only 5.74%.

Remember that since state-specific funds are less diversified, they're riskier. And while no money fund has defaulted, none is guaranteed. But for a bit more risk, you can keep more money beyond the taxman's grasp.

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