Advanced Diploma of Financial Planning (ADFP) Practice Test

Which of the following is a characteristic of taxable money market funds?

1. They offer tax-free interest income

2. They invest in stocks exclusively

3. They can yield solid annual returns

4. They are subject to income tax on earnings

The correct answer is: They are subject to income tax on earnings

Taxable money market funds are specifically designed to generate income that is subject to income tax. This means that the interest earnings from these funds are not exempt from taxation, making option D the correct choice. Investors in taxable money market funds receive interest income that is added to their taxable income, which could potentially push them into a higher tax bracket depending on their total earnings. These funds typically invest in short-term, low-risk financial instruments like Treasury bills and commercial paper, which yield interest that is taxed at the investor's ordinary income tax rate. Other options present characteristics that do not apply to taxable money market funds. For instance, tax-free interest income pertains to municipal money market funds, not taxable ones. The assertion that they invest exclusively in stocks is inaccurate, as money market funds primarily invest in cash equivalents and short-term debt instruments rather than stocks. Finally, while some money market funds can yield reasonable annual returns, they are generally lower than returns offered by riskier investments, so stating that they can yield solid annual returns may not accurately reflect their conservative nature.