Money Market Fund

A money market fund pools investors’ money and lends it for days or months at a time through Treasury bills, repurchase agreements backed by government securities, bank certificates of deposit or commercial paper, depending on the fund. The interest earned, minus the fund’s expenses, is paid out as dividends, which many shareholders reinvest in more shares. Because the holdings mature quickly, the yield follows short-term interest rates.

As with any mutual fund, you buy shares from the fund and sell them back to it, generally on any business day, at the net asset value (NAV) per share. Retail and government funds may use special pricing methods to hold that NAV at $1.00, so your balance grows by adding shares rather than through a rising price. Institutional prime and institutional tax-exempt funds must let their NAV float, so their price can drift slightly above or below $1.00.

SEC Rule 2a-7 is what separates these funds from a short-term bond fund. It limits how long and how risky the holdings can be and requires a cushion of easily sold assets:

Funds sort along two lines: what they hold and who may invest. Government funds put at least 99.5% of total assets in cash, government securities and fully collateralized repurchase agreements. Prime funds add short-term corporate and bank debt such as commercial paper and CDs, which usually pays a little more for a little more credit risk. Tax-exempt, or municipal, funds generally hold 80% or more in short-term municipal securities whose interest is free of federal income tax.

The second line is retail versus institutional. A retail fund must limit its owners to natural persons, and it may keep a stable $1.00 price. Institutional prime and tax-exempt funds serve businesses and other large investors, float their price and must charge a liquidity fee when withdrawals are heavy. Government funds can keep a stable price either way. The table below compares the five combinations.

Within a type, funds differ mainly in cost. The yield you receive is what remains after the fund’s expense ratio, and because the gross yield is small, a few tenths of a percent in expenses take a large share of it.

The names are nearly identical, but the protection is not. A money market deposit account is a bank deposit, insured by the FDIC up to $250,000 per depositor, per insured bank, for each ownership category. A money market fund is an investment, and the FDIC does not insure it, even when a bank sells it.

If the brokerage holding your fund fails, SIPC treats money market fund shares as securities and works to restore missing shares, up to its $500,000 limit per customer. SIPC protects custody, not value: it does nothing if the fund itself loses money.

Cash you may need soon usually sits in one of four places:

Money market funds are among the lowest-risk investments, but low is not zero. A stable-price fund must reprice its shares if the market value of its holdings strays more than half a cent per share from $1.00, which is called breaking the buck. It very rarely happens, but when it does shareholders lose money, and in turbulent markets the fear of it can set off a run.

A fund can no longer lock your money up for a while. Rules the SEC adopted in 2023 removed the power to gate, or temporarily suspend, redemptions and leaned on liquidity fees instead. Institutional prime and institutional tax-exempt funds must charge redeeming shareholders a fee on any day net redemptions exceed 5% of net assets, unless the cost is de minimis. Any non-government fund, retail or institutional, must also charge a discretionary fee of up to 2% when its board finds one in the fund’s best interest; government funds may opt in. A fund that is closing down may still suspend redemptions permanently so it can liquidate in an orderly way.

The likelier risk is slow erosion. After tax, the yield can trail Inflation, so the balance loses purchasing power even though the share price never moves.

The IRS says to report money market fund payouts as dividends, not interest. For most funds the income underneath is interest, so the dividends are generally nonqualified and taxed at ordinary rates, up to 37% federally in 2026, whether you take them in cash or reinvest them. In a taxable account they also count toward the 3.8% net investment income tax once modified AGI passes $200,000 ($250,000 married filing jointly, $125,000 married filing separately).

Interest on Treasuries you own directly is exempt from state and local income tax. Whether a government fund can pass that exemption through depends on your state’s rules, so check the fund’s year-end tax information.

Tax-exempt funds pay exempt-interest dividends, reported in box 12 of Form 1099-DIV and on line 2a of Form 1040. They are free of federal income tax, but the part from private activity bonds, in box 13, can be taxed under the alternative minimum tax. Tax-exempt interest still counts toward provisional income for Social Security taxation and toward the income test for Medicare IRMAA surcharges. Inside an IRA or 401(k), the account’s own withdrawal rules decide the tax instead.