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Open-ended tax-free money market funds are generally composed of pools of municipal bonds and produce income that is exempt from federal tax, and exempt at the state and local tax levels to residents of the issuing state of the underlying bonds.
Open-ended municipal bond funds maintain cash on hand to pay redeeming investors at par, and purchase new securities to meet new demand in the fund without changing the net asset value. Like fully-taxable money market funds, these funds are 2a-7 funds and hold only short duration securities (usually no security in the portfolio has a maturity more than 180 days away). Open-ended tax-free municipal money market funds, therefore, are much safer than and are a very different form of investment than closed-ended municipal bond funds which are based on a defined pool of assets, and may have a defined net asset value, but can trade above or below that value due to supply and demand of the fund shares.
For those in the highest federal tax bracket (35%) who live in states and localities with high income taxes, interest earned in certain tax-free money market funds may be very competitive with other alternatives on a tax equivalent basis. For example, a resident of New York City (one of the highest taxing localities with local and state taxes at 12.15%) in the highest local and state and federal brackets would find that a New York municipal money market fund would an effective after tax rate of close to twice the quoted yield (i.e., a quoted yield of 1.10% would yield the a taxable equivalent of close to 2.20%). Fully taxable money market funds, by contrast, produce income which is fully taxable, and are more appropriate for those in lower tax brackets or those residing in states which have low state and local taxes.
Vanguard (which has a $3,000 minimum balance), for example, has tax-free money market funds for residents several different states, all of which yield between 1.00% and 1.25%. Vanguard's tax-free funds are considered very attractive, in part, due to their low expense ratios, which are ordinarily around 0.13%.
In order to determine the taxable equivalent of a tax-free municipal or a municipal product, divide the tax-free rate by the reciprocal of your cumulative federal and state tax obligations.
(Tax-free municipal rate) / (1 - Your federal tax rate - your state tax rate)
Most of the leading open-ended tax-free municipal money market funds are 2a-7 funds and should be covered until September 19, 2009 by the US Department of the Treasury rule guaranteeing the principal balance in the funds as of that date. In addition to be certain that your fund is covered, it is important to bear in mind that the rule has certain limitations and does not cover funds invested after September 19, 2008. Therefore, it is possible that in the event of large scale municipal defaults, investors will lose interest accrued after September 19, 2008 and those investors who invest after that date could lose principal.
Due to the recent decline in interest rates, and the changes in credit quality of the underlying issuer and of the insurers, there has been a fair amount of fluctuation recently in the rates of tax-free municipal money market funds tend to vary dramatically from week to week.
Compare management fees, which are calculated and reported in terms
of expense ratios. Expense ratios tend to range between 0.10% and
0.50%. Over any length of time, those funds with the lowest management
fees tend to outperform those with higher fees.
Check the rules of the fund's prospectus carefully to see what rules
bind its managers. Be sure that the fund invests only in the highest
rated debt securities and that it maintains ample amounts of cash on
hand to pay shareholders who are selling their shares.
Those funds with lower weighted average maturities (WAM) which is
measured in terms of days will generally outperform in rising interest
rate environments, and underperform in declining interest rate
environments.