Money market funds have been around for more than 35 years, revolutionizing the way investors hold cash. Paying far higher interest than most bank savings accounts, they helped investors keep pace with high inflation in the 1970s. More recently, however, banks have fought back with high-yield savings accounts, which pay competitive rates that are sometimes higher than the typical money market fund. These accounts have landed a knockout punch on money market funds, but as we'll see, the money markets aren't down for the count yet.
In particular, money market funds still have a leg up on bank products like savings accounts and CDs. With the combination of more investment choices and flexibility in transferring money among your investments, money market funds can still play a vital role in your overall portfolio.
Money market funds come in several different types and can be broadly defined into two categories: taxable and tax-exempt. While savings accounts and CDs are always subject to federal income tax, tax-exempt money market funds hold short-term municipal debt that is generally tax-free. Although the stated yields on these tax-exempt funds are lower than their taxable counterparts, their after-tax yield is often higher, especially if you're in the highest tax brackets. Depending on what state you live in, you may be able to find a money market fund that is tax-free for state income tax as well.
Among taxable money market funds, there are several subcategories. Some funds, for example, hold only short-term Treasury bills. These funds are the safest, and their income is usually tax-free for state -- but not federal -- income tax purposes. Other funds hold debt of government-sponsored agencies, such as Fannie Mae (NYSE: FNM ) and Freddie Mac (NYSE: FRE ) , which aren't necessarily as safe as Treasuries. These government money market funds pay higher rates than Treasury funds, but they often don't qualify for the same state income tax breaks. Still other funds hold short-term corporate debt. These funds usually have the highest rates, but they also bear a higher default risk.
In addition to the greater number of choices for investors, money market funds offer investors greater ease in moving their money than savings accounts. Most money market funds offer check-writing services that allow investors instant access to their money merely by writing a check. In addition, you can transfer money between your money market fund and your bank account, as well as exchange money market shares for stock and bond mutual funds offered by the same company.
In contrast, money in a savings account can require several steps to get it where you want it. While high-yield savings accounts offer direct links to other bank accounts, you'll often have to arrange for a transfer and then wait for it to take place before writing a check or making a further electronic transfer to its final destination. And while CDs sometimes offer better rates, they aren't readily accessible at any time without penalty.
You'll typically find offerings from popular fund providers Fidelity and Vanguard among the top-yielding mutual funds in each category. For instance, Vanguard's Prime Money Market tops this week's Bankrate list with a yield of 5.22%. Fidelity's Cash Reserves and Government Reserves check in at 5.09%. Among tax-exempt money market funds, Alpine Municipal leads the field with a 3.91% yield, followed by Vanguard's Tax-Exempt fund at 3.87%.
Having short-term savings is vitally important for a successful financial plan. You can learn more about money market funds and other savings options in our Savings Center. On the other hand, if you're looking for ways to find cash to put in your savings, consider taking a free trial of our personal finance service, Motley Fool Green Light. Each month, you'll get new tips that will let you pay less or save more. Before you know it, you'll have plenty of money in whatever savings vehicle you choose.
Fool contributor Dan Caplinger has both money market funds and high-yield savings accounts. He doesn't own shares of the companies discussed in this article. Fannie Mae is an Inside Value pick. The Fool's disclosure policy gives you the best information around.