NEW YORK (CNN/Money) - I've been doing some research about tax-free money-market funds. I noticed the return I can expect from these is significantly lower than the return I could get in a money-market account at my bank. Is it smart to put money in a taxable account and just pay the taxes on the interest, or should I go the tax-free route?

-- Shiva Sekhar, Hillsborough, New Jersey

Deciding whether to go tax-free or taxable comes down to a pretty simple calculation. Before I get into that, however, I want to make sure that you and anyone else reading this understand that money-market funds and money-market accounts are two entirely different things.

A money market fund, which is usually just referred to as a money fund, is a type of mutual fund. The fund holds very short-term debt securities -- Treasury bills, corporate commercial paper, bank repurchase agreements, that sort of thing -- and passes along the interest on those securities to the fund shareholders.

Naturally, the fund first deducts expenses for managing the fund. You can determine the level of those expenses by checking out the fund's expense ratio, a figure that calculates the costs as a percentage of assets.

A tax-free money fund operates pretty much the same as a taxable one, except that it invests in short-term debt issued by states, municipalities and other entities that are exempt from federal taxes.

But there's one big difference between stock and bond mutual funds and money funds. The share price, or net asset value, of stock and bond funds fluctuates daily along with the prices of stocks and bonds. Money funds, on the other hand, seek to maintain a constant share price, or net asset value, of $1 per share.

I say "seek" to maintain because this isn't a guarantee. A default by the issuer of one of the securities in the fund or a big, big spike in interest rates could conceivably knock the fund's share price below $1 -- known as "breaking the buck" in money fund circles -- but this is exceedingly rare. And, in my opinion, not something you should spend much time worrying about, especially if you're investing in money funds offered by well-known established fund companies.

A money-market account, on the other hand, is nothing more than an interest-earning account offered by banks and some other financial institutions. A money market account usually pays more than a passbook savings account, but it also limits the number of checks you can write and the number of transfers and withdrawals you can make from the account. Basically, it is the banks' way of competing with money market funds.

Unlike a money fund, a money market account qualifies for federal deposit insurance. But I don't see that as much of an advantage because the chances of a money market fund "breaking a buck" are pretty slim. While money fund yields are pretty much determined by the level of short-term interest rates, money fund yields are set by the bank.

As a practical matter, the bank's rate will reflect the general level of interest rates, although a bank has more wiggle room for lowering or raising its rate. The interest on money market accounts is taxable; there are no tax-free versions.

So, back to the taxable vs. tax-exempt issue. To determine whether you're better off in a taxable money fund, a taxable market account or a tax-free money fund, you've got to consider the yields all three accounts are paying as well as your tax rate.

Recently, for example, the average yield on money market accounts was 1.58 percent, according to BankRate.com. Meanwhile, the average yield on taxable money market funds was 0.93 percent and the average yield on tax-free money funds was 1.03 percent, according to imoneynet.

On the face of it, the money market account would seem the best choice. It's paying more than that of taxable money funds, so it's clearly the better taxable alternative. And its yield is higher than that of tax-free money funds too.

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Ah, but remember, you're paying tax on the tax-free fund's interest. So to truly compare the taxable money market account and the tax-free fund, you've got to put them on a level playing field.

One way to do that is to calculate what's known as the taxable equivalent yield for the tax-free fund. To do that, you divide the tax-free yield by 1 minus your marginal tax rate. So if you're in the 27 percent tax bracket, you would divide the tax-free yield of 1.03 percent by 0.73, which gives you a yield of 1.41 percent.

This tells you that for someone in the 27 percent tax bracket, a tax-free yield of 1.03 percent is the equivalent of a taxable yield of 1.41 percent. Since that's less than the 1.58 percent on a money market account, the money market account is the better choice. In fact, you would have to be in a tax bracket of 35 percent or higher for the tax-free fund to be a better deal.

This doesn't mean that a taxable money-market account is always the better deal for someone in the 27 percent bracket and a worse deal for someone in the 35 percent or higher bracket. The spread between taxable and tax-free rates changes all the time, as does the spread between taxable money funds and taxable money market accounts.

In fact, rates are a bit screwy now in two senses. First, it's more typical for money fund rates to beat those on money market accounts. I suspect the reason it's the other way around now is that the Fed's relentless rate cuts over the past year have simply pushed short-term rates so low that banks see an opportunity to gain a bit of market share from money funds by offering slightly higher rates on their accounts.

What's also strange is that the yield on taxable money funds is actually lower than that on tax-free money funds. That usually goes the other way too, the reason being that tax-free funds can offer lower rates because of their tax advantage.

The reason this relationship has been flipped around, I suspect, is that in these jittery times the demand for Treasury bills has so high that it's bid up their prices so high that T-bill yields are actually lower than those offered on short-term tax-exempt securities. And since other taxable securities typically take their cues from T-bills, their yields too are lagging those of short-term tax-exempt issues.

The end result is that, on average, tax-free money fund yields exceed those of taxable yields.

At some point, the relationship between tax-free yields and taxable yields will revert to normal, as, I suppose, will the relationship between yields on money funds and money market accounts. But you can always tell which is the better deal for you at any given moment by comparing the yields at the Web sites mentioned above, and then going through the little calculation I described.

One final note: in some cases you can buy a tax-free fund that sticks to the securities of one state. If you are a resident of that state, then the income you receive is not only exempt from federal taxes, but state levies as well.

To calculate the taxable equivalent yield for such a fund, you've got to take into account not just your federal tax rate but your state rate as well. You can spare yourself the drudgery of actually doing the calculation, however, by going to the Taxable Yield Comparison Calculator at the Bond Market Association's site.

Gee, I'll bet you never knew that taxes could be so much fun.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.