Money market funds: How they can help you invest

Money market funds are an investment tool that allow you to deposit cash and earn interest on it. You can also use those funds to buy share of stock.

Zack Sigel

Zack Sigel

Published April 26, 2019

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A money market fund is an investment tool. As a type of mutual fund, money market funds let you invest in several types of assets (or securities) at once, which are chosen by the financial institution who holds your account. As the securities increase in value, you earn a higher rate of return on your money market fund.

As of 2019, money market funds earn about 1.80% per year on average, with some funds earning about 2.20% or more.

Money market funds, which are also called money market mutual funds, cost $1 per share, with a percentage of every share going toward each security in the fund. That one-for-one ratio means they function similarly to a money market account, which is a type of savings account that earns interest.

However, because money market funds are tied to the growth in value of their securities, you may potentially earn a higher rate of return by investing in them instead of traditional deposit accounts. Many retirement accounts also require you to use a money market settlement fund to move contributions into your IRA and 401(k).

In this article:

How money market funds work

A money market fund is a way to invest your money and gain a modest but stable return. Rather than earning interest, like you would with a savings account, your investment buys tiny percentages of other assets that should theoretically gain in value.

Many people use a money market mutual fund attached to a brokerage account to buy shares of stock. This may result in a higher rate of return, but you risk losing money if the market dips.

The financial institution you open your account with is required by the U.S. Securities and Exchange Commission (SEC) to maintain a net asset value (NAV) — the cost to buy one share of the fund — of $1 per share.

But how much your investment grows depends on the securities in the money market fund’s portfolio.

Money market fund portfolios

Money market funds are comprised of several types of securities. Most money market funds invest a major percentage of their funds in government securities like Treasury bills, which have a very stable but very conservative rate of growth.

Commercial paper, or short-term promissory notes issued by companies, also comprises a major percentage of money market funds. Essentially, a corporation may sell commercial paper to a financial institution, which becomes like a type of loan that the company has to pay back with interest.

These securities form the bulk of most money market funds. While they don’t gain a lot of value, their relative stability ensures that you usually won’t lose any money, either.

Some money market funds also invest in certificates of deposit (a savings deposit account) and repurchase agreements (short-term purchases of securities that are soon sold back to the seller at a slightly higher price).

Cost of using a money market fund

There is no cost to invest in a money market fund, although some funds may require you to invest a minimum amount. However, there is a cost associated with managing the fund, which is expressed as an expense ratio.

The expense ratio is typically very small, typically less than three-fourths of one percent per year. It will be subtracted from your gains of your assets, so you should look at not only the fund’s performance but also its expense ratios when comparing investment opportunities.

Insurance

Money market funds, like other mutual funds, are not insured by the FDIC or any other government agency. (Deposit accounts, like your checking or savings account, are FDIC-insured.)

A lesser-known nonprofit organization called the Securities Investor Protection Corporation (SIPC) may insure your money market fund. The SIPC is not a government agency but its existence is mandated by federal law.

The SIPC insures up to $500,000 per account per person, of which $250,000 can be cash. This insurance protects against the loss of your funds because of failure of your financial institution, but it does not protect against the risk of your investments losing value.

Are money market funds taxable?

Whether the money market fund is taxable or not depends on the type of account you have.

If your money market fund is part of a brokerage account you use to make investments or trade stocks, then you may be taxed on the growth of any assets in the account. There is only a small handful of tax-exempt money market accounts.

But if your money market fund is used to fund a retirement account — for example, if it’s a money market settlement fund attached to an IRA or 401(k) — then you won’t be taxed on it as long as you don’t withdraw it before retirement.

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When to invest in a money market fund

A money market fund may be a good idea for growing a rainy-day fund, since its returns may sometimes exceed traditional savings accounts, especially high-yield savings accounts. However, as an investment tool, it may not offer as much growth as other options.

But, with most financial firms, you’ll need to use a money market settlement fund to fund your investment accounts.

Whether your account is a brokerage account you use to make trades or invest money, or a retirement account that you contribute to for your nest egg, you may need to first deposit money into a money market fund before using the fund to purchase shares of your preferred assets.

Dividends

Dividends are sometimes paid out to people who own shares of a company. The more shares you own, the higher your dividend payments will be, when the company does well.

Depending on the financial institution, you may be able to reinvest those dividends right back into the stock, allowing you to purchase partial shares of the stock with the dividends. You can also have the dividends repaid into the money market settlement fund.

Accessing the money in the a money market fund

Cash in your money market fund can be transferred between accounts, including to other investment accounts, or to your bank.

Similarly, money you make from selling shares of a security often goes directly into a settlement fund.

Money market funds vs money market accounts

Money market funds and money market accounts are easy to confuse. They sound similar and even offer similar rates of return.

A money market account is a savings account at your bank or credit union. If you deposit cash, you’re guaranteed to be paid at least some amount of interest on that cash every month. You’ll never lose your initial deposit unless you withdraw it yourself. The best money market accounts offer interest of 2% or more.

Cash you put in a money market fund, however, is invested in the fund’s portfolio of securities. Because the value of your investment depends on the value of those securities, it’s possible, but highly unlikely, to lose money on the investment.

But most investors don’t keep their cash in a money market fund for very long, as they use it to fund purchases of stocks or other securities that could gain value much faster. The stock market has historically averaged about an 8% rate of return, but cash in a money market fund may not exceed 2%.

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