Tax-Free Money Funds Seen as an Alternative

Investors with cash in fully taxable money market mutual funds might want to consider whether a tax-free money fund would be a better alternative, some financial pros say.

Tax-free money funds invest in short-term IOUs of states and municipalities. Taxable money funds typically buy IOUs of companies and the federal government.

In an unusual twist, the average yield on tax-free funds is higher than the average yield on taxable funds, said IMoneyNet Inc. of Westborough, Mass., which tracks money fund data.

The average annualized seven-day simple yield of tax-free funds now is 0.54%, compared with 0.52% for taxable funds, IMoneyNet said.

After taxes, the 0.52% yield on taxable funds would mean an even lower net yield, depending on an investor’s tax bracket.

This is the fifth time in the last 12 months that the tax-free yield has risen above the taxable yield, said Pete Crane, managing editor at IMoneyNet. Before this period, tax-free fund yields had always been lower, he said.

The tax advantage means that state and municipal IOUs normally should yield less than taxable IOUs, Crane noted. But this year, investors have been demanding higher yields from state and municipal borrowers because of concerns about budget woes in states such as California and cities such as Pittsburgh, he said.

Though tax-free fund yields can be more volatile than taxable yields, Crane said high-tax-bracket investors who own taxable funds should at least look into tax-free funds as an alternative.

In California, a number of mutual fund companies offer tax-free money funds that are exempt from both federal and state taxes.

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-- Tom Petruno