NEW YORK (CNN/Money) -
I'm looking to park some cash in a money-market fund and I've noticed that some companies' taxable and tax-exempt money funds are paying roughly the same yields. Am I missing something, or in such a case should I go with the tax-exempt money market?
-- Anonymous, New York
You're absolutely right, my eagle-eyed friend. In some cases, taxable money funds and tax-exempt funds are throwing off yields that are pretty close even before taking the tax-exempt fund's tax advantages into account.
Case in point: the seven-day yield on Vanguard's Prime Money Market fund as of November 30 was 1.73 percent, according to the iMoneyNet Web site, compared with a 1.58 percent for Vanguard's Tax-Exempt Money fund.
Assuming you're in the 25 percent tax bracket, that means the tax-exempt fund would pay you a taxable equivalent of 2.11 percent, or close to half a percentage point more than you would get in the taxable fund.
You'd do even better in the tax-exempt fund, if you're in a higher tax bracket, and less well, naturally, if you're in a lower bracket (although even in the 10 percent bracket, you would still come out slightly ahead).
Since we're talking about money market funds here, I don't think there's an appreciable level of risk between the taxable and tax-exempt variety of funds. Which means you are getting more yield for virtually the same amount of risk -- so, no, you're not missing something.
Look closely at the fund family
But before you start moving all your money fund stash from taxable to tax-exempt funds, there are a few things you ought to keep in mind.
First, while the taxable and tax-exempt yields in some fund families' money funds are very close, don't assume that's the case for all fund companies.
According to iMoneyNet, the average for all taxable money funds as of November 30 was 1.40 percent vs. 1.07 percent for all tax-exempt funds -- a difference that's quite a bit larger than the gap between the Vanguard funds.
Given that tighter spread, someone in the 25 percent tax bracket would come out only slightly ahead by going into the tax-exempt fund (1.43 percent vs. 1.40 percent).
Careful with the numbers
Another thing to keep in mind is that what I've quoted here are seven-day yields that are annualized. That fact has two important implications.
One is that just because tax-exempts may be a better deal today doesn't mean that will be the case next week, or a month or a year from now. Seven-day yields change every seven days according to the supply and demand for the short-term debt instruments that money funds hold.
The other implication is that someone in the 25 percent bracket investing in the tax-exempt Vanguard fund mentioned above would get an extra half percentage point or so of yield only if that spread between the two funds held over the course of a year, which isn't likely.
In fact, you're not really even locking in that difference for the next seven days since these yields are backward looking -- i.e., what the fund paid over the past seven days -- and not a prediction of future yields.
When choosing a money fund, remember that some companies juice their yields a bit by temporarily lowering expenses. Which means that a fund, whether taxable or tax-exempt, that may look like a great deal at one point, could become less compelling if the company begins charging full expenses.
Compare oranges to oranges
One final note: before you can tell whether a particular tax-exempt or taxable money fund is a better deal, you've got to put them both on an equal footing.
The way investment pros usually do that is by calculating the taxable equivalent yield for the tax-exempt fund and then comparing that figure to the yield for the taxable fund. In short, you're comparing both funds' yields on a pre-tax basis.
While you can do that on your own with a calculator (just divide the tax-exempt yield by one minus your tax rate), you can also do it by going to the Tax-Free vs. Taxable Yield Comparison Calculator at the Investing In Bonds Web site.
One caveat, though: the site's calculator automatically factors in state taxes, which is fine if you're considering a money fund that's also exempt from state taxes, but muddies the waters if you're evaluating a national tax-exempt fund whose income isn't exempt from state taxes.
If that's the case, when the calculator asks what state you live in, just choose a state that has no income tax such as Alaska, Florida, Nevada, South Dakota, Texas, Washington or Wyoming, and then let the calculator do its thing.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."