To Tax or Not To Tax: That is the Money Market Question

Most money market funds are taxable and invest in things like Treasury Bonds and CD’s but there’s also a decent selection of tax-free funds that invest in the short-term obligations of tax-exempt entities such as your local government. While the yield from these tax-free investments are a bit lower than their taxable counterparts, any return you receive is typically exempt from our friendly Uncle Sam.

So which is better?

To determine the right investment for you, you need to take the tax issue out of the equation. Your taxable versus your tax-free as it were and luckily, there’s a pretty easy formula to help you make your decision.

Tax-free yield / (1.0 – your tax bracket) = Tax-free equivalentNo, no… Don’t run away yet. It’s not as difficult as you might think. Let’s say we’re considering two funds: a taxable fund that pays 2.5% and a tax-free fund that pays 2.0%. If your tax bracket is 20%, your equation is going to look like this:

2.0 / (1.0-.20) = 2.5In this instance, the tax-free equivalent is 2.5%, the same yield as your taxable fund. But lower the tax bracket to 15% and the results work out a little differently:

2.0 / (1.0 -.15) = 2.36%That’s a.14% less return than the taxable fund. But what if you increase your tax bracket to 25%?

2.0 / (1.0-.25) = 2.67%Now the tax-free fund is clearly the better choice, all other things (like expense ratios and investment selections) being equal.

Of course, neither of these investments will be your key to retiring early, but at least you’ll be getting the most from your investing dollars which, after all is what smart investing is all about.