An alternative to high-yield bank savings accounts are money market funds held in brokerage accounts. Although both money market funds and savings accounts can change their interest rates paid at any time, comparing their actual returns can be confusing.
Comparing Returns
Money market funds usually report their 7-day annualized yield (also listed as just yield, or 7-day yield), which takes the interest paid net of expenses for the last 7 days and assumes that this average continues over an entire year. Compounding is not taken into account, so the 7-day yield should be compared to a bank account’s annual percentage rate (APR).
Some funds also list the 7-day effective yield (also listed as compound yield), which does take into account compounding via the reinvesting of dividends. So the 7-day effective yield should be compared to annual percentage yield (APY).
Here are two examples from Fidelity and Vanguard where they list both. In this case the Fidelity fund would be comparable to a bank account earning 5.07% APR or 5.19% APY.
Since banks usually advertise APY, you can convert if needed using this APY to APR calculator. Keep in mind that since these are moving 7-day averages, the numbers given will change from week to week.
Other Types of Money Market Funds
The above comparison is meant for the most common “taxable” money market funds, which are taxalbe on both federal and state levels just like a bank’s savings account. In addition to these, there are a variety of specific types of funds like Treasury funds (exempt from state income tax) and municipal tax-exempt funds (exempt from federal income tax), and state-specific municipal funds (exempt from both fed and state taxes) that offer special tax consideration.
In this case, you can use a tax-equivalent yield calculator to complete the comparison.
But Is The Risk The Same?
While not eligible to be FDIC-insured as they are not banks, money market funds do have to follow strict guidelines as to maintain the highest credit quality and lowest volatility of the underlying investments. The share is always kept at $1. Due to the recent concerns with mortgage-backed bonds, Fool.com recently asked Is Your Money Market Fund Safe? In my opinion, the risk is a definitely higher than a bank account, but if you hold your money market funds from a respected firm like Vanguard or Fidelity, I would sleep just as soundly, as these companies would repay the funds with their own assets rather than let them falter.
There are also other practical differences between specific banks and specific money market funds, which I am ignoring here.
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DOnt ignore the practical and technical differences. The only thing i can think of at this time: federal and state taxes. Interest from banks are placed on 1099INT, and i believe is taxed in every state, and of course the federal. However, interest from mutual funds’ money market funds is taxed federal, and may or may not be taxed on state level (depends on what state; and i believe a generalization is that you can reduce your income by the % the money fund has in US obligations.)
SE – That’s actually not what I was thinking about for ‘practical differences’, but that is a good point. I was only thinking about taxable money market funds when I wrote this post, and have added some information to the original post for clarification.
In my experience, sometimes the Treasury money market funds can have a higher tax-equivalent yield than the taxable one. One example of this is with Zecco brokerage’s money market options.
Treasury MMFs will be just as safe as FDIC-insured bank accounts. Even something like Vanguard’s Prime MMF has most of its assets in federally insured instruments (IIRC around 75%).
I agree Andy, I think it’s the other 25% that people are worried about 🙂 Here are the holdings of Vanguard Prime MFF as of 6/30/07:
Bankers Acceptances 6.0%
Certificates of Deposit 49.9%
Commercial Paper 20.7%
Other 4.9%
U.S. Government & Agency 18.5%
Yankee/Foreign 0.0%
Total 100.0%
It’s interesting that it holds 50% CDs, allowing them to take a long term stake since they don’t expect people taking mass withdrawals.
Does US Gov’t and Agency mean both Treasuries and GNMA/FNMA bonds are lumped together?
I don’t quite get it. In the comparing returns section, you say the 7-day yield should be compared to a bank account?s annual percentage rate (APR). Then in the next paragraph, it states 7-day effective yield should be compared to annual percentage yield (APY). Is there a “not” missing from the first sentence since compounding isn’t included? In the Fidelity example, should the 5.07 or the 5.19 be used to compare to the APR? Thanks.
“Yield”, “Annualized Yield” = APR
“Effective Yield”, “Compound Yield”, or “Compound Effective Yield” = APY
Yes, it’s confusing. I’ll clarify above more.
5.07 – APR
5.19 – APY
I use the Vanguard Prime MM as my primary savings. I have no qualms about it not being FDIC. One could argue that Vanguard is more fiscally responsible than the Federal Gov’t. Plus it allows me to invest through direct exchange and keeps life simple. I don’t worry about chasing the best teaser rate all over the world wide web for a scant few basis points.
… and then there is “Tax Equivalent Yelds”. WHat does that mean?
This post reminds me of a burning question I’ve had for some time.
If I buy a money market mutual fund and hold it for a year, then am I taxed at the long term capital gains rate for the increased value? Or is the increased value counted as regular interest somehow?
If I could be getting 5% plus, taxed at long term capital gains rates, that would beat the pants off getting taxed at my regular income rate (in the case of money saved in high interest savings accounts).
Is there a similar MM fund that you can buy from Etrade Roth account? Both FDRXX and VMMXX are not available from ETrade.
Thanks!
Thanks for clearing it up. I’ve been pretty confused on this topic for a while. It’s almost as confusing as trying to understand the APR and APY for a mortgage.
Still looking for that 20% APR money market fund.
Haven’t found it yet…….;)
Aneta – ?Tax Equivalent Yield? is your effective yield after taxes. To figure this you calculate the yield of a savings account or MM fund after federal and state taxes. For example, Vanguard offers a tax-exempt money market fund (VMSXX), and the compound yield is currently 3.53%.
If someone is in the 25% marginal tax bracket with no marginal state tax consideration, the Tax Equivalent Yield for the prime MM (VMMXX) is 3.92% and 3.53% for VMSXX.
Therefore you’d be 0.39% ahead if you chose VGMMX over the tax-exempt MM VMMXX.
MD – On regular taxable money market funds, you will get paid your yield via unqualified dividends. As the dividends are not qualified for the special 15% dividend rate, they get taxed as ordinary unearned income – just like interest from a bank savings account.
For a MMF, the share price should always stay at $1 so there won’t be any capital gains.
Thanks Ted Valentine. I am looking specifically at Fidelity’s FNYXX and trying to compare it to 5.05% APY on an HSBC online savings account though and figure out which one is better if I live in the NY state… The seven day yeld fell down to 3.12% and the compund effective is at 3.17% which doesn’t sound that great but then the tax equivalent yelds are much hgher. See below.
Tax Equivalent Yields4(%) as of 08/13/2007
Tax Rate 25 28 33 35
Yield 4.65 4.84 5.20 5.36
How do I figure my tax rate so I can compare these rates? This getting complicated.
Aneta, your tax rate is your marginal tax rate which is determined by your income and filing status.
Here’s a quick link to some table I found on google.
http://www.invest-2win.com/Brackets.html
Add to it your state tax rate. Since the FNYXX should also be exempt from state taxe, add the state tax rate your federal marginal rate to come up with your entire marginal rate =MR. So instead of just looking at the table to figure out the equiavalent tax yield, you can calculate it by:
Equivalent Taxable Yield = Rate/(1-MR)
I too have a smilar question.
I am trying to simplify my finances.
I have a couple of Online savings account and am trying of open a Vanguard MMF?
Wonder which one is better? I have my 401k, 403b and Roth in Vanguard.
Best explanation on Taxable versus Tax-Exempt. Also has a calculator where you can enter the yield/compound yield all at once to get a direct comparison. link
For those in E-Trade, SHV or BIL if you have large enough sums to overcome trading fees. These ETFs hold extremely short Treasuries so they effectively act like a traded money market fund.
If you only have a small amount of money in E-Trade, you have to pick from their NTF fund list. Back when I was still with E-Trade, PIASX was the best option for that purpose. You will not be able to withdraw until 90 days later without penalty so it effectively acts like a 90-day CD.
I agree. Simplify your finance should be a top priority for those who are leading a busy life like myself. I have Capital One 5% APY Checking which I can pay all my bills. Everything else just go toward my 401K and Roth.
Anita – Quick guide for Federal marginal tax rates / income.
25% = single 349k
Use the calculator Mossy linked. Plug and chug. Watch out for the AMT. Don’t know much about that.
FDRXX pays dividends… not interest…. filed my 1099-DIV on it last year.
Fidelity money market funds are in serious trouble people!
Google “fidelity, moneymarkets and subprime”
Get out now while you still can!! I can’t belive the otherwise ingenious owner of this site is not aware of the danger to PRINCIPAL let alone interest in the money markets right NOW
Also, think twice about the attractve 5.6% savings rates being offered by IndyMac Bank and Countrywide- they are both near insolvency…
We are waiting for the eywall of the perfect financial storm- get ready this is gonna get UGLY
Barrons has an excellent and thorough article on money market funds and their exposure to subprime debt.
“Vanguard Group Inc…. has a policy of never buying CDO commercial paper for its $90 billion in money market funds or… in fixed-income mutual funds.” (bless them)
Wells Fargo, Schwab, BofA and Fidelity are all cited as owning CDO’s in money market funds. In the case of Fidelity, FCASH is cited as holding CDO’s (FCASH ironically, pays very low interest.) For Wells, “Advantage” funds held the debt. For BofA, “Columbia” funds. For Schwab it was an institutional fund.
How do the Money Market expense ratios fit in? I have an ING Direct account and have been considering transferring some or all into VMMXX. Currently VMMXX Compound Yield (2.37%) < ING APY (3%). Assuming the ING rate doesn’t change, what would VMMXX Compound Yield have to be in order to surpass the ING APY and compensate for the 0.24% expense ratio?
“Money market funds usually report their 7-day annualized yield (also listed as just yield, or 7-day yield), which takes the interest paid net of expenses for the last 7 days and assumes that this average continues over an entire year.”
In other words, the stated compound yield already takes into account the expense ratio.