Federal Money Market Fund

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sport
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Federal Money Market Fund

Post by sport »

Today, I received the Vanguard Money Market Annual report. While reviewing it, I noted that the Federal MM fund compares very favorably with the Prime MM fund. For the year ending Aug 31, 2007, the Federal Fund average total return was 5.2% and the Prime Fund total return was also 5.2%. For ten years, the Federal total return was 3.7% and the Prime was 3.8%. According to these data, the returns of the two funds are very close, over both long and short terms.

However, the Federal Fund is partially state tax exempt, while the Prime fund is fully taxable, or nearly so. Historically, if I remember correctly, the Federal fund state tax exemption varies between 20% and 40% approximately. Therefore, it appears that for those investors subject to state or local income taxes on fund dividends, the Federal Fund will yield higher after tax income.

There are many Boglehead postings that recommend the Prime MM fund, and almost none suggest the Federal fund as an alternative. Perhaps we should reconsider these recommendations.

Similarly, the Treasury MM fund is 100% state tax exempt. However, its one year and ten year returns are 0.3% less than the Prime fund. A little arithmetic will show whether or not it is a better choice after taxes considering the applicable state income tax bracket.

Best wishes,

Jeff
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jeffyscott
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Post by jeffyscott »

Depends on your state, in mine only treasuries are tax-exempt, so the Federal fund is pretty much fully taxable since its description says: most of the securities held by the fund are neither guaranteed by the United States Treasury nor supported by the full faith and credit of the U.S. government.

The treasury fund yield is 15% less than prime right now, does anyone pay a state tax rate that high? And if they do, one of the tax-exempt money market funds might still give better after tax yield.
The two greatest enemies of the equity fund investor are expenses and emotions. ― John C. Bogle
xenial
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Post by xenial »

jsl11 wrote:Historically, if I remember correctly, the Federal fund state tax exemption varies between 20% and 40% approximately.
Here's the data:
1999 - 27.40%
2000 - 23.29%
2001 - 26.77%
2002 - 31.11%
2003 - 35.88%
2004 - 56.64%
2005 - 32.76%
2006 - 22.06%

Best wishes,
Ken
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DaveTH
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Post by DaveTH »

Vanguard Prime Money Market has 24% of its holdings in U.S. Government & Agency securities. So you will still get some state tax exemption.
xenial
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Post by xenial »

DaveTH wrote:Vanguard Prime Money Market has 24% of its holdings in U.S. Government & Agency securities. So you will still get some state tax exemption.
Those securities are probably not all from issuers which qualify for the tax break. A footnote in Vanguard's 2006 tax document states -
Investments in U.S. government obligations may include the following: Banks for Cooperatives, the Commodity Credit Corporation, the Federal Deposit Insurance Corporation, Federal Farm Credit Banks, the Federal Financing Bank, Federal Home Loan Banks, Federal Intermediate Credit Banks, Federal Land Banks and the Federal Land Bank Association, the Federal Savings and Loan Insurance Corporation, the General Insurance Fund, Government Services Administration (GSA Public Building Trust Participation Certificates), the Production Credit Association, the Student Loan Marketing Association, the Tennessee Valley Authority, the U.S. Postal Service, and the U.S. Treasury Department (bonds, notes, bills, certificates, and savings bonds).
The US Government obligations percentages for Prime Money Market in 1999-2006, respectively, were 8.83%, 4.11%, 8.88%, 13.50%, 32.04%, 20.00%, 7.18%, and 4.67%.

Best wishes,
Ken
TheEternalVortex
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Post by TheEternalVortex »

For some states you only get the tax break if the majority of the fund is invested in such securities.
xenial
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Post by xenial »

TheEternalVortex wrote:For some states you only get the tax break if the majority of the fund is invested in such securities.
Indeed. Another footnote in Vanguard's 2006 US Gov't Obligations document is
**This fund meets the threshold requirements for California, Connecticut, and New York, which require that 50% of the fund’s assets at each fund’s tax year-end consist of U.S. government obligations.
The ** superscript appears after the following entries: Admiral™ Treasury Money Market Fund, Inflation-Protected Securities Fund, Intermediate-Term Treasury Fund, Long-Term Treasury Fund, Short-Term Bond Index Fund, Short-Term Treasury Fund, and Treasury Money Market Fund.

Best wishes,
Ken
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grabiner
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Post by grabiner »

jeffyscott wrote:Depends on your state, in mine only treasuries are tax-exempt, so the Federal fund is pretty much fully taxable since its description says: most of the securities held by the fund are neither guaranteed by the United States Treasury nor supported by the full faith and credit of the U.S. government.

The treasury fund yield is 15% less than prime right now, does anyone pay a state tax rate that high? And if they do, one of the tax-exempt money market funds might still give better after tax yield.
The 15% spread is atypical, and there is the slight risk reduction; if Treasury and Prime have the same yield after tax, you should prefer Treasury. Using the ten-year yields, the spread is just under 8%, which is a fairly common state tax rate. (In Maryland, for example, the state and county tax is 7.95% in all the suburban Washington counties.)

In theory, you could bounce back and forth between Treasury and Prime Money Market according to the yield spread, but there wouldn't be much difference. If you have $50K in a money market fund and pay any significant state tax, you are probably better off sticking with Admiral Treasury even in the rare situations that the spread is higher than your tax rate (it's now 13% but was 3% over the last ten years). If you have less than $50K, the gain from switching between the two funds is just a few dollars, so you should choose one based on historical returns and stick with it.
Wiki David Grabiner
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