Money Market Mutual Funds: A Better Savings Account

If you don't have $1,000 or more moldering away in a savings account, this article may not interest you. If you do have some cash saved up, you may be wondering whether a savings account is the best place to keep it. Sure, it's liquid, but the interest rates are only slightly better than those offered by your sock drawer and may be only slightly better than the inflation rate. One alternative is a money market mutual fund.

The main reason people use banks to hold their money isn't because of the lucrative returns from interest rates, it is because the bricks, sensors and a tempered steel safe convey a sense of security that a sock drawer can't match. On top of the physical security of a bank, there is the protection provided by the U.S. government. The Federal Deposit Insurance Corporation (FDIC) guarantees the bank will not lose your money. The limit for this coverage is $250,000 per account and per owner.

Money market mutual funds are safe in a different way. There is no backing from the federal government, but the SEC carefully hems in money market funds. They generally only invest in financially reliable securities, and all the investments must have an average maturity of less than 120 days. This results in a lot of government issues (municipal, state, federal), which are the safest debt instruments. They have a lower yield than the average market, but a better rate than your savings account.

For savings accounts, the two biggest fees are associated with a minimum balance requirement and transaction fees. Depending on the bank and the exact savings account, these fees vary, but they are usually not a problem for those with a large amount of money in a savings account.

For money market funds, there are several fees investors should be aware of before investing. The biggest is the expense ratio, which is a percentage fee charged on the fund for management expenses. For money market funds, these fees are typically very low, usually below 0.5%. Also, there may be balance requirements or transaction fees.

A savings account might give you anywhere from a 0.1 to 1.7% return on your investment. Money market funds have a range of 1 to 3%. This doesn't mean that you will always get 3% returns, but it does mean your chances of getting up to 3% returns are higher than with a savings account.

As with bonds, the performance of money market funds is closely tied to the interest rates set by the Federal Reserve. When rates in the market are at very low levels, as they were from 2002 to 2004 and 2007 to 2009, these types of funds tend to generate returns on the lower end of the range, not much more than a savings account. So be aware of the current interest rate environment and how it compares to your savings account rate before you move your money to a money market fund.

Money market funds are comparable to savings accounts as far as liquidity goes. There is usually free check-writing, automated electronic exchange services and telephone exchange and redemption. If you are sure the money will be sitting idle for more than three months, Treasury bills or CDs are a guaranteed option, but they come with penalties and fees for early redemption. Both a money market account and a savings account are for people who need access to the money.

There is a range of funds to help you relieve the different types of tax burdens. If you find yourself in a high state tax bracket but a low federal tax bracket, you can invest in a U.S. Treasury money market fund. There are also funds that are tax-free. The tax exemptions are based on what securities the fund invests in and whether they are local or federal debt issues. Tax-free in this case refers to the dividends—there is no tax deduction for the money you put into the funds. With some research, you should be able to find a fund that will meet your tax needs.

The various types of funds all invest in the same basket of securities within their section (municipal, Treasury, etc.), so the returns of a particular fund might vary a tenth of a percent from the others in its section. A fund with low operating costs, therefore, will generally produce better yields. Annual operating expenses of 0.5% or less should be your measuring stick when sifting through the funds. If a fund company is successful, the larger amounts of capital it controls will translate into lower operating expenses for investors. Although these investments are considered low risk, in their attempt to outperform, some have reached for higher-yielding instruments outside the norm, including collateralized debt obligations (CDOs) backed by subprime mortgages.

Changing from a savings account to a money market account is more of a psychological leap than it is a change in actual mechanics. With a money market fund, you can still write checks and transfer money into your checking account when you need it, but it is no longer a savings account, it is an investment (albeit a short-term one).

The returns are better, the security is comparable, and taxes and access are easily handled. Despite this, people believe a savings account is somehow more solid. If you can get around that type of thinking, a money market mutual fund will help you to see some returns from the money you are keeping as an emergency fund or waiting to invest.