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(Tax) Free Parking

By Smart Money
Published | Updated

What are the best tax-free funds that provide a stable parking place for money?

QUESTION: What are the best tax-free funds that provide a stable parking place for money?


ANSWER: We'll be honest with you: Given today's low interest rates, there really aren't any fantastic tax-free places to park money these days. Consider that the yield on Vanguard's Tax Exempt Money-Market fund (sorry, no snapshot available) is a mere 1.57% (based on its seven-day compound yield) -- and right now, that's the top performing tax-free money-market fund, according to iMoneyNet, an industry-tracker. Granted, this yield doesn't factor in the tax break. And during a time when most equity funds are deep underwater, a positive return -- even an anemic one -- may be worth getting excited about.

But nonetheless, we still need to ask you: Are you sure that you need a tax-free fund? "A lot of investors weigh the tax savings too heavily," says Peter Crane, iMoneyNet's managing editor. "If you're not in the very top income-tax bracket -- or in a state with high taxes -- don't even bother."

That said, with interest rates so low, right now the tax-free money-market funds are actually a better deal for investors in lower tax brackets, too. (This would most likely change should interest rates rise.) To know for certain whether a tax-free fund makes sense for you, you need to calculate what's known as the "taxable equivalent yield." To do so, divide the tax-exempt yield by the difference between 1.0 and your tax bracket. So if you were in, say, the 30% tax bracket, the taxable equivalent yield on a tax-free fund yielding 1.57% would be 1.57/(1.0 - 0.30), or 2.24%. Considering that even the best taxable money-market funds currently have yields below 2%, this is clearly a better deal for someone in this tax bracket or above.

Assuming you do decide a tax-free fund is the way to go, what should you look for? Aside from the yield (which is affected by the duration of the fund's holdings), you should also consider whether you want a fund that's free of state as well as federal taxes. If you live in a state with high taxes -- like New York, California or Massachusetts -- that can obviously be an added advantage. But depending on where you live, you might have a hard time finding a fund that specializes in your state. (iMoneyNet provides a list of the top tax-free money-market funds, including state funds.) And in some cases, the national funds may still be a better deal (even if you have to pay state taxes) since they have a larger pool of investments to choose from, which could result in a higher yield, says John Bonnell, portfolio manager of Strong Funds' Municipal Money-Market Fund.

Another thing you should factor in is expenses. "There is almost no better determinant of how a money-market fund is going to perform than how much it charges in fees," says Eric Jacobson, senior analyst for investment-research firm Morningstar. "It's awfully hard to add extra value any other way than having a low expense ratio." These days, the average national tax-free money market fund has an expense ratio of 0.53%.

And if you are subject to the Alternative Minimum Tax, or AMT (a nasty additional tax system for the "wealthy" that an increasing number of Americans are subject to), then you need to be additionally careful when selecting a money-market fund, warns Andrew Clark, senior research analyst at fund-tracker Lipper. Some of these funds are loaded up with securities that are subject to the AMT -- which could increase your own AMT bill. If you are concerned about a potential AMT hit, make sure that you go with a money market fund that has the phrase "tax-free" or "tax exempt" in the name. These funds can't have more than 20% of their portfolios invested in securities subject to the AMT, explains Pam Tynan, senior portfolio manager for Vanguard's short-term/municipal offerings. Funds that have "municipal" in their name can hold more than that. On the other hand, AMT-susceptible securities tend to have higher yields, so if you're sure you won't be socked with the AMT, you might want to find a fund that labels itself this way.

What about other investment options? Well, if you're willing to move up the risk ladder a bit (which is probably a good idea if you think you may be "parked" for more than three to six months), you could consider a short-term muni-bond fund, which these days have an average yield of 1.96%, according to Morningstar. Just make sure that the higher fees justify the yield and that you invest in a fund that gives you the liquidity you need. And if you're willing to consider the taxable realm, you should check out our short-term investing guide, which includes suggestions like loan-participation funds.