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When It Pays to Be Tax-Free

Investors who keep their cash in savings accounts have seen their interest rates cut quite sharply over the past few months. ING's (NYSE: ING  ) ING Direct and HSBC's (NYSE: HBC  ) HSBC Direct online savings accounts, for example, now shell out just 3.1% and 3.55% APY, respectively -- down from more than 4.5% last year.

The reason for the decline is quite simple: The Fed has attempted to jump-start the economy by lowering interest rates. Savings accounts carry variable rates, so these accounts periodically adjust with the current interest rate environment.

In many cases, when savings accounts don't cut it, investors can turn to money market accounts like Vanguard Prime Money Market and Fidelity Cash Reserves for higher yields. Money markets like these invest in high-quality short-term debt such as Treasury bills, CDs, and commercial paper from reliable corporations like Toyota (NYSE: TM  ) , General Electric (NYSE: GE  ) , and Wal-Mart (NYSE: WMT  ) .

At last check, however, neither of these money markets yielded more than 3.5%. Moreover, the interest is fully taxable. For an investor in the 25% tax bracket, that means an after-tax yield of 2.62%. Not that great, considering inflation now sits above 4%.

Nowhere to run to, baby?
If you're in a higher tax bracket, tax-free money markets could be a viable alternative. Tax-free money market funds invest in short-term municipal debt, the interest from which is tax-free at the federal level and sometimes at the state level. For example, the Vanguard Tax-Exempt Money Market currently yields 3.03%, which, at first glance, looks downright paltry.

On the other hand, if you're in a 25% tax bracket, that 3.03% tax-free yield turns into a much better 4.04% when put on the same level with a fully taxable fund.

The formula to determine your tax-equivalent yield: tax-free yield / (1-your federal tax bracket).

If the tax-equivalent yield is greater than the fully taxable alternative, the tax-free money market could make sense.

Where do I sign up?
Before you change your savings over to a tax-free money market, it's worth noting that most of them have a minimum initial investment of more than $2,000. Many also have a minimum balance you need to carry to avoid additional fees or liquidation.

In other words, these tax-free municipal funds are not the best vehicles to stash the few hundred dollars you have saved to repair your car. They're more useful for investors in high tax brackets who consistently have more than a few thousand dollars in savings. Money market funds also generally feature check-writing and direct-deposit functions, which can be advantageous for someone needing an alternative to a no-interest checking account.

As always, do your own due diligence to determine if a tax-free money market makes sense to you.

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