Money market funds have long been touted as potentially tax-friendly options, with so-called “dividends” typically reported as interest income. But as the tax and rate environment evolves in 2025, are they still the most tax-efficient choice? 

In this article, we’ll review federal and state tax treatment of money market funds, compare them with alternatives like Treasury bills and municipal funds, and highlight key factors to consider when seeking a tax-friendly cash vehicle. By the end, you’ll have a clearer view of where to park your cash this year—without overpaying taxes.

📌 Also Read: Standard Deduction vs Itemized Deduction: Which One’s Better?

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Table of contents

What Are Money Market Funds?

Money market funds are a way to keep your cash earning interest without taking on much risk. These funds invest in short-term, high-quality assets like Treasury bills and commercial paper, aiming to maintain stability while offering better yields than a typical savings account. Platforms like Smart Yield automate the selection of tax‑efficient money market funds.

If you’re looking for a low-risk place to hold your money with quick access when needed, it’s worth understanding how money market funds work in today’s rate environment.

Why More People Are Turning to Cash Alternatives

Even with relatively higher yields today, cash parked in a standard savings account may lose purchasing power as inflation hovers around 2.4 percent annually. Money market funds offer a potential solution that could help you stay ahead of inflation while keeping your money accessible. 

Here are some of the key benefits:

✅ Potentially outpace inflation with yields above 4 percent

✅ Same-day liquidity for emergencies or short-term goals

✅ Exposure to high-quality investments like Treasury bills and commercial paper

✅ Platforms like Smart Yield automate the selection of tax‑efficient money market funds.

📝 Note: These funds typically aim to keep their value steady, but it’s still important to check for fees or investment minimums before moving your money.

Current Yields and Rates

As of June 2025, here’s how some key rates compare:

If you’re evaluating a money market fund, here are a few things to look for:

  • 7-day yield: Gives you a quick view of recent performance after fees
  • Expense ratio: Lower costs could mean more of the yield stays with you
  • Liquidity and minimums: Make sure the fund fits your access needs and balance size

Money Market Funds vs. Other Cash Vehicles

Not all cash investments are taxed the same way. Depending on your income level and where you live, the differences can be significant. While money market funds generally offer ease of access and stability, other options may deliver better tax treatment, especially if you’re holding larger balances or planning to park your funds for a while. 

To help you decide where to keep your cash, let’s look at how the most common choices are typically taxed.

How Money Market Funds Are Taxed

Money market funds may feel similar to a savings account, but their tax treatment differs slightly. Here’s what you need to know:

✅ For most taxable money market mutual funds, earnings are typically reported as ordinary dividends on Form 1099-DIV (box 1a) even though they function more like interest. Bank money market deposit accounts, on the other hand, report earnings on Form 1099-INT.
✅ At the federal level, these earnings are taxed as ordinary income.
✅ In many cases, they’re also subject to state and local income tax, similar to bank interest.

Most money market funds distribute earnings daily. While those amounts may seem small, they still count toward your total taxable income each year.

How Other Cash Options Compare

Depending on your financial goals, the following alternatives may offer more favorable tax treatment:

Treasury Bills

  • Interest is taxable at the federal level but exempt from state and local income taxes.
  • You’ll report interest as “original issue discount” when the bill matures.

Certificates of Deposit (CDs)

  • Interest is taxed both federally and by most states, similar to money market funds.
  • Taxable in the year it’s earned, not necessarily when withdrawn.

Ultra-Short Bond Funds

  • Distributions often include both interest and capital gains.
  • You’ll be taxed at ordinary income rates for interest and possibly at capital gains rates, depending on how long the fund holds its assets.

Municipal Money Market Funds

  • These generally offer federal tax-free income
  • May be state tax-free if you invest in bonds issued in your home state
  • Exempt-interest income appears on Form 1099-DIV and goes on line 2a of your 1040.

📝 Note: All of these options come with trade-offs. Some may offer higher yields, while others provide more tax relief. The right choice depends on how you balance income needs, tax brackets, and accessibility.

📌 Also Read: IRS | Publication 550 (2024), Investment Income and Expenses

Choosing Your Most Tax-Friendly Cash Investment

Not all cash vehicles are created equal. Even if two investments offer the same yield, differences in fees, tax treatment, and liquidity can impact your after-tax return. Here’s what to consider if you’re looking to keep more of your earnings in 2025.

Fees, Minimums & Access to Funds

Small line-items can quietly erode potential earnings:

  • Expense ratios quietly reduce your return. Let’s say a fund offers a 4 percent yield but charges a 0.15 percent fee. That fee might seem small, but it lowers your actual return to 3.85 percent. 

✏️ Hypothetical Example: On a $10,000 balance, that 0.15 percent fee equals $15 over the course of a year.

  • Minimum investment requirements vary. Some funds may ask for a minimum of $1,000 to get started, which may not be ideal if you’re setting aside a smaller amount. Others have no minimums at all, so it’s worth comparing before choosing.
  • Liquidity matters. Most retail money market funds allow same-day access to your cash, but some impose short waiting periods or redemption fees. With certificates of deposit (CDs), early withdrawals typically come with penalties. In some cases, that can include losing part of your earned interest.
  • Evaluate whether Smart Yield’s automated tax-equivalent fund allocation delivers higher after‑tax returns.

These small factors can chip away at your potential returns, especially if you need to withdraw funds earlier than planned.

📌 Also Read: FDIC | Saving for the Unexpected and Your Future

Rule Changes and What They Mean for Your Taxes

Recent regulatory updates have changed how some cash investments work and how they affect your taxes:

  • Some money market funds no longer guarantee a $1.00 share price. Institutional prime and municipal funds have floating net asset values (NAV), meaning you could redeem shares for slightly less than you put in. That difference may count as a capital loss, which could help offset interest income on your tax return.
  • Redemption gates are gone but liquidity fees are in. The SEC no longer allows funds to temporarily freeze withdrawals. Instead, a 1 percent liquidity fee is automatically applied when net redemptions exceed 5 percent of the fund’s assets.
  • Those fees aren’t taxed as income. Instead of being reported separately, liquidity fees simply reduce what you receive when you redeem your shares. This affects your capital gain or loss but doesn’t trigger a new tax event.
  • Municipal money market funds may offer tax advantages. Interest earned from these funds is typically exempt from federal income tax. If you invest in a fund tied to your state of residence, you might also avoid state income tax, though that depends on where you live.

Key Takeaways

Money market funds remain a popular place to hold cash in a higher-rate environment. But whether they’re the most tax-friendly option in 2025 depends on a mix of factors like fund type, fee structure, access rules, and how your state treats interest income. Some investors may find more value in tax-exempt municipal funds, while others might prefer the stability of government-backed options or Treasury bills.

When comparing options, look beyond yield. Review expense ratios, redemption terms, and any recent regulatory changes that could affect how your income is taxed. These small details could influence how much you ultimately keep.

For those with larger balances or more complex tax situations, consulting a financial or tax advisor could help avoid missed opportunities or costly surprises at tax time. Consider Smart Yield if you want automated, tax‑sensitive allocations across money market funds—reducing fees, tracking yields, and optimizing your after‑tax return.

📌 Want to explore more? Check out our other articles on retirement accounts, cash strategies, and investment planning.

Disclaimer:

The Carry Learning Center is operated by The Vibes Company Inc. (“Vibes”) and contains generalized educational content about personal finance topics. While Vibes provides educational content and technology services, all investment advisory services discussed on this website are provided exclusively through its wholly-owned subsidiary, Carry Advisors LLC (“Carry Advisors”), an SEC registered investment adviser. The information contained on the Carry Learning Center should not be construed as personalized investment advice and should not be considered as a solicitation to buy or sell any security or engage in a particular investment, accounting, tax or legal strategy. Vibes is not providing tax, legal, accounting, or investment advice. You should consult with qualified tax, legal, accounting, and investment professionals regarding your specific situation.

The accounts, strategies and/or investments discussed in this material may not be suitable for all investors. All investments involve the risk of loss, and past performance does not guarantee future results. Investment growth or profit is never a guarantee. All statements and opinions included on the Carry Learning Center are intended to be current as of the date of publication but are subject to change without notice.

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