Tax-exempt money market securities are available, allowing states and other municipalities to borrow money for short-term needs. There are various tax-free money market instruments that provide investors with interest that is exempt from federal income taxes and, in some instances, state and local taxes as well:
- Bond, tax, and revenue appreciation notes
- Municipal commercial paper
- Variable-rate floaters
- Other, more exotic instruments
The level of safety of these instruments depends on the creditworthiness of the issuing state or municipality.
Investors in higher federal tax brackets can realize a significant overall tax advantage by including tax-free money market funds in their investment picture. Although tax-free money market funds typically yield less than their taxable counterparts, investors accept a lower yield because they don’t have to pay federal (and perhaps state and local) taxes on the income. Depending on the investor’s tax bracket, tax-free money market funds may provide higher after-tax income.
To learn more about tax-free investing, whether it’s right for you, and how to develop a tax-free investment strategy, read the following report:
Investors should be aware of the alternative minimum tax (AMT). The AMT may result in additional tax you would have to pay with your regular income tax if your tentative minimum tax on your alternative minimum taxable income (which includes certain tax-free income), after an exemption amount, exceeds your regular tax. Municipal bond funds investing in private activity bonds may result in interest income not exempt from the AMT. There are a number of things you can do to minimize your AMT liability, including choosing AMT-free municipal bond funds and money market funds, spreading out your gains over several years, and planning your income and deductions. T. Rowe Price recommends that while investors should consider the impact of the AMT, it should not be the primary factor in their investment decisions.