Money market funds

In short

A friend of mine once kept her savings in a checking account for years, and she never knew it was earning almost nothing. If you have cash you want to keep safe, a money market fund is one place people park it. It is a fund, not a bank account, and that difference matters. A fund holds short term debt, and its yield moves up and down as interest rates change. The fund company charges a small yearly fee, so look at the expense ratio before you pick one. Money in a money market fund is not insured by the FDIC, so read what the fund itself says about risk. Check the current yield on the fund company's own page, because it changes often.

The whole of it

What it is

I once watched a neighbor argue with his brother over two things that sounded alike. One was a money market account at a bank. The other was a money market fund at a brokerage. They are not the same, and I think a good many of us have mixed them up at one time or another.

A money market account is a deposit account at a bank. The FDIC, which is the Federal Deposit Insurance Corporation, insures deposits up to a set limit per depositor, per bank, per ownership category. The FDIC explains that limit on its own website. A money market fund is a different animal. It is a mutual fund, which means many people pool their cash and a manager buys things with it. The fund buys very short term debt, such as Treasury bills, which are loans to the government that come due in months, and other short loans to banks and companies.

Many of these funds try to keep their share price steady, and the SEC's Investor.gov site explains how that works. Your interest shows up as extra income rather than a rising share price. A steady price is a goal, not a promise. A fund can, in rare cases, fall below that steady price. The SEC, the Securities and Exchange Commission, writes the rules for these funds, and Investor.gov has plain pages about them.

How it works

If you are holding cash in a brokerage account, you have probably seen a line that says sweep or cash position. Often that cash sits in a money market fund. Here is the simple path of the money.

You send in cash. The fund uses it to buy short debt. That debt pays interest. The fund passes the interest to you after taking its fee. The fee is called the expense ratio, and it is a percent of what you hold, taken out a little each day, so you never write a check for it. Say a fund earns 5 percent before fees and charges 0.20 percent. The fee comes out a little each day, so the exact result shifts a hair with compounding. As a rough guide, 5.00 minus 0.20 is about 4.80 percent.

Funds come in a few kinds. A government fund keeps nearly all its money in Treasury bills and similar government debt. A prime fund can also buy short loans to companies. A tax exempt fund buys short debt from states and cities, and its income may be free of federal income tax. Each kind has its own risk and its own yield.

Rules apply to some funds. Under SEC rules, certain funds sold to ordinary investors must keep a share of their holdings in assets that turn to cash fast. Some funds may also charge a fee or hold back withdrawals when cash is draining out in a hurry. The fund's prospectus, the long document that describes the fund, tells you which rules apply to that fund.

Now the matter of tax. Interest from a fund is usually taxed as ordinary income. That means it is taxed at the same rate as your wages. The fund will send a Form 1099 after the year ends if you earned enough interest in a taxable account. Interest from a government fund may be free of state income tax in some states, though that depends on the state and the fund. Check the fund's own tax page.

The numbers, and where to find yours

I have found that people feel a little lost looking at a fund page, so let me point to the spots that matter. You want to find four things.

First, the yield. Funds report a seven day yield, which is the income over the past seven days, stated as a yearly rate. It is a snapshot, not a forecast. It will change. The fund company posts it on the fund's page, and it is dated, so look at the date.

Second, the expense ratio. This sits near the top of the fund page and in the prospectus. A lower number means more of the interest stays with you.

Third, the minimum. Some funds ask for $0 to start, and others ask for $1,000 or more. The prospectus names the amount.

Fourth, the fund type. Look for the words government, prime, or tax exempt, because they tell you where the money goes.

If you want to compare the yield against a bank, the FDIC publishes national average deposit rates on its site, and the rule for the insurance limit is the current figure, which the official source publishes each year. For the tax side, the IRS explains how interest income is reported in its publications, and your Form 1099 will show the figure for your own return. The yearly tax rates themselves are set by law and shift by year, so look them up under the current figure, which the official source publishes each year rather than guessing.

A worked example

Let me tell you about a woman named Marlene. She is a nurse, forty one years old, and she set aside $20,000 as an emergency fund. She put it in a money market fund with a seven day yield of 4.50 percent and an expense ratio of 0.25 percent. The yield she saw on the page was already after fees, as funds report it, so she did not subtract the fee a second time.

Marlene wanted to know what a year might bring. She did the math plainly. $20,000 times 4.50 percent is $900. So at that yield, held for a full year, she would earn about $900. She knew the yield would drift, so she treated the figure as a rough guide and not a promise.

Then she thought about the fee. The fee on $20,000 at 0.25 percent is $20,000 times 0.0025, which is $50. That $50 is already folded into the yield she saw, so her take stayed near $900. She just wanted to know what the fund cost her. Fifty dollars a year felt fair to her.

Next came tax. Marlene is in a taxable account, so the $900 counts as income. Say her federal rate on this income is 22 percent, a plain figure picked only for this story. The real rate depends on the tax year and on her filing status. $900 times 22 percent is $198. She keeps $900 minus $198, which is $702. That is her after tax return, about $702 on $20,000, or 3.51 percent. The check is simple: $702 divided by $20,000 is 0.0351.

Here is the part she liked best. If rates fall to 3.00 percent next year, her income falls too. $20,000 times 3.00 percent is $600. She would not be locked in. That is the trade. The fund moves with rates in both directions.

Where it goes wrong

I have made my share of plain mistakes with money, and I would rather tell you about the common ones than pretend they do not happen.

The first mistake is thinking a fund has the same protection as a bank deposit. It does not. The FDIC does not insure money market funds. A fund may aim for a steady share price, but a fund can lose money. The fund's prospectus and the SEC's Investor.gov site explain this risk. That is rare, but it is real.

The second mistake is chasing the highest yield without reading why it is high. A higher yield can come from holding riskier debt or from a short term burst. Look at the fund type before you look at the number.

The third mistake is forgetting the yield moves. A rate of 4.50 percent today is not a rate of 4.50 percent next spring. Plans built on a fixed yield can fall short. Always leave some room.

The fourth is ignoring the fee. A fee of 0.50 percent costs $100 a year on $20,000, because $20,000 times 0.0050 is $100. Over many years, that adds up.

The fifth is tax surprise. Interest in a taxable account is income, and it shows up on your return. A person who forgets this can owe more in April than expected. Putting the fund inside a retirement account changes how the tax works, so read the rules for that account.

Last, there is the quiet cost of holding too much cash for too long. Cash is safe from big swings, but it may not keep pace with prices over many years. That is a trade worth knowing, not a rule to follow.

Questions to answer before you leave this page

What is this cash for, and when will you need it? Is it an emergency fund, a down payment, or money waiting for a decision? Do you know whether the fund you are looking at is a government fund, a prime fund, or a tax exempt fund? Have you read its expense ratio and its seven day yield, and noted the date on each? Are you comfortable that the fund is not FDIC insured, and have you read what its prospectus says about risk? Is the account taxable, and have you thought about how the interest will appear on your Form 1099? Would a bank money market account or a plain savings account fit better, given the insurance it carries? And if the yield dropped by a full point next year, would your plan still hold together?