2001 FINANCIAL GUIDE

Smart places to stash your cash

Don't let your dollars sit idle in a checking or savings account. After taxes, you'll barely keep pace with inflation. Try these strategies, instead.

By Deborah Grandinetti
Senior Editor

How well are you managing your cash? Have you set aside enough for planned purchases and the unexpected? Is your money earning a reasonable rate of return? Are you confident your short-term investment strategy is working as hard for you as you work for your money?

If you're not sure, here's help.

Determining how much cash to set aside—plus where to keep it and when to move it—is worth the effort. True, this may not give you quite the same thrill as tracking your tech stocks. But it will significantly boost your earnings over the years, through compounding of slightly higher returns or by allowing full maturation of investments you might otherwise have had to liquidate prematurely for emergencies. (You'll save on associated penalties, too.) A good cash investment strategy can also help you keep a cooler head with regard to your long-term investments.

"Carving out emergency money definitely helps the long-term portfolio," says Columbus, OH, financial planner Jill Gianola. "You can be more aggressive if you know your short-term needs are covered."

Map out how much cash you'll need, and when

To create a strong cash position, start by figuring out how much money you'll need in the near future to cover purchases like a car, furniture, home remodeling, or tuition for the kids. Include only those big ticket-items that your paycheck wouldn't cover, says Champaign, IL, financial planner Mary McGrath. Project your needs out as far as you can—ideally five years. You don't want to put in the stock market money that you'll definitely need within five years, because then you risk not having all of it when you need it.

After you've reviewed your upcoming expenses, write the headings, "Needed in six months," "Needed in one year," "Needed in two years," etc., on a piece of paper. List the amounts and the approximate dates when you'll need the money.

Next, consider how much to sock away for an emergency. Although the rule of thumb is three to six months' worth of living expenses, let your circumstances dictate the amount. The more precise you are with this figure, the better. You don't want to leave yourself so short that you're forced to sell assets to cover an unanticipated household emergency, like a roof that needs replacing. Nor do you want to keep more in cash investments than necessary.

To get a fix on the right amount for your emergency fund, consider several factors. One is your disability coverage, says Chicago financial planner Joel M. Blau. The policy should specify a waiting period for benefits if you file a claim. Is it 30 days? Three months? Six months? Once payments begin, what percentage of your living expenses will they cover? Comparing the policy's payout with your own projections about your cash needs will give you an idea of any potential shortfall.

Another factor to consider is job security. If your employment contract is up for renewal or your job seems less than secure, consider asking recruiters how long it could take you to find a suitable new position in your market, so you'll know how long you may be dependent on your emergency fund. Looking at these two issues will help you determine how many months' worth of basic living expenses your reserve should cover. You may want to add something extra for unexpected car or household repairs.

Now, fine-tune your estimate. For instance, if you already have enough invested in bond funds or no-load mutual funds to get you by for a month or more, you may not need to set aside as much cash. You can also minimize your reserve fund if you can quickly tap another source of cash, such as a home-equity line of credit or stocks you're ready to liquidate. If your spouse is receiving a regular paycheck, take that into account, too.

Get the biggest bang for your emergency funds

Once you decide on an amount for your emergency cash reserve, add it to the number you listed under "Needed in six months." You'll want to keep this money in accessible, risk-free cash investments.

That doesn't mean your savings or checking account. Unless the interest rate is high enough to compensate for what you lose to taxes—and to outpace inflation, which is averaging 3.5 percent—you'll end up with a negative rate of return. "We call that going broke safely," Blau quips. So skip the savings account, and leave only enough in checking to pay the bills and maintain the bank's minimum balance.

A smarter choice is money-market investments, which recently offered about 4 to 6 percent interest. Your options include money-market deposit accounts at banks, taxable money-market mutual funds, and tax-exempt money-market funds. Their interest rates fluctuate.

Banks often require a minimum balance of $500 to $2,500 in a money-market deposit account. You can withdraw cash as often as you want, but if your balance falls below the minimum, you'll pay a penalty or end up with a lower interest rate. These are government-insured accounts, and they tend to pay less interest than taxable money-market mutual funds.

Right now, some taxable money-market funds are paying in excess of 6 percent. Minimum investments can be as low as $500, although $3,000 or so is more typical. You can usually write an unlimited number of checks against the fund, generally for a minimum of $250 to $500. Terms vary, so shop around.

Because Uncle Sam doesn't guarantee them, these funds aren't quite as safe as money-market accounts at banks. And to generate higher yields, some funds take more risks than others. Although the average maturity of a money-market fund's holdings can't exceed 90 days, the riskiest funds push that to the max. Tamer funds keep the maturities shorter. You can check a fund's average maturity by looking in the prospectus or asking a customer service representative.

When shopping for funds, look for ones that have low operating expenses, says New York City financial planner Gary H. Schatsky. He favors the Vanguard Prime Money Market Fund and the Vanguard Tax-Exempt Money Market Fund for that reason.

Tax-exempt money-market funds may make sense if you're in a high tax bracket, says Flemington, NJ, financial planner Al Zdenek Jr. Some top-quality ones are paying over 4 percent these days. That may not seem like much, but look at it this way: If you're paying more than 5 percent in state taxes and you're in a 39.6 percent federal tax bracket, you could forfeit almost 45 percent of your taxable money-market fund's earnings. A tax-exempt fund may provide a greater return (see table below).

Park six- to 12-month cash in tried-and-true places

Mary McGrath recommends putting money you'll need in six months to a year into certificates of deposit or Treasury bills. "These can give you a higher return than the money-market alternatives, but with less flexibility," she says.

Before investing, be sure to compare current CD and T-bill rates, to see which offer the better yield. Right now, CDs tend to be a little more competitive, especially over longer terms. The national average for a taxable six-month CD is 6.3 percent, and for a one-year CD it's 6.6 percent. T-bills with the same maturities average 6.3 and 6.1 percent, respectively.

With CDs, which are federally insured, you put your money in a bank or savings and loan for a fixed term—typically six, 12, or 36 months. If you tap the money early, you'll pay a penalty of one to six months' interest, but you'll probably lose less money that way than you would by keeping the cash in a checking account.

CDs, however, don't make sense when interest rates are rising rapidly, as they were earlier this year. During periods like that, McGrath says, it makes more sense to leave your cash in a money-market fund than to lock in a rate with a CD. Later, after interest rates have leveled off, you can transfer the money to CDs.

Planners sometimes "ladder" CDs when their clients aren't sure what their cash needs will be over the next couple of years. You could, for instance, put $1,000 each into CDs that mature in one, two, three, four, and five years. If the one-year CD matures and you don't need the cash, you can put it into a five-year CD, knowing that your two-year CD will mature in a year.

Treasury bills, which mature in three, six, or 12 months, are another option. They require a minimum investment of $1,000. They may not return as much as corporate bonds, but because they're issued by the US government, they're very safe. Another advantage is that you don't have to pay state or municipal taxes on your earnings. You'll owe federal taxes, however.

Here's how T-bills work: Big institutions bid on them at public auction, and you get the average of the yields they negotiate. A $10,000 one-year T-bill might be discounted to $9,500, for example. You send in your certified check for $10,000 and immediately get back the $500 difference. When the T-bill matures, you receive the full $10,000. Since you paid only $9,500 and got $10,000 at maturity, that's a return of about 5.3 percent.

Newspapers often publish yields for T-bills. If yours doesn't, call the nearest Federal Reserve Bank. It will have a 24-hour recording reporting the most recent auction prices and yields. You can also check for recent rates at www.bog.frb.fed.us/releases/h15/current.

To purchase T-bills, visit or write to a Federal Reserve Bank, fill out an application, and provide a certified check. Alternately, a stockbroker or bank can buy them for you, for a fee. The quickest and cheapest way to buy T-bills, however, is via the Internet. Visit the "TreasuryDirect" page on the Web site of the US Bureau of the Public Debt (www.publicdebt.treas.gov/sec/sectrdir.htm).

For longer periods, use bonds

Money-market instruments, CDs, and T-bills are safe places to stash money you'll need relatively soon. They'll provide you with modest returns. But if you won't need the cash for several years and are willing to assume a little more risk, consider short-term bond funds. These may boost your total annual return by a few percentage points. Jill Gianola advises her clients to sock away enough to cover 20 percent of their annual spending in a short-term bond fund or in CDs, and 10 percent more in a money-market fund, as a hedge against emergencies.

Short-term bond funds offer advantages over individual bonds. You can invest small sums to start, like $1,000 to $3,000, and make regular small contributions. Also, if you have to cash out early, you can sell just some fund shares, rather than having to cash out an entire bond, says Gianola.

On the flip side, bond funds, unlike bonds, don't have a definite maturity date. And unlike CDs, they don't remain constant in value. Rather, the market value changes daily. How much you get when you sell your shares depends on market conditions at the time.

"Bond funds can be a bit volatile," says Schatsky, "so I'd steer clear of them right now, in light of the high rates of return on money-market funds."

"If you need the money in a definite period of time, you're better off not taking the risk," adds McGrath. "Unless interest rates are stable or coming back, you could lose principal. I've had plenty of physicians tell me they were using bond funds for cash needs, but found they had less money a year later."

What if you think you may need a certain sum in two or three years? Consider high-quality individual corporate bonds or Treasury notes, but keep the duration short, Al Zdenek says. "Then the value won't fluctuate much. If you have to sell, your downside risk will be a lot less than it would be with a 10-year bond."

A more adventurous option: Financial planner Ronald W. Rogé, of Bohemia, NY, recommends target-term trusts for clients who won't need the cash for two to five years. A target-term trust is essentially a closed-end bond fund that has a target maturity date and trades like stock. It pays monthly income, but the payment stream isn't as constant as the income from regular bonds. That's because the cash is continually reinvested in shorter-maturity securities as the trust's maturity date approaches. (Last year, the income stream from such trusts ranged from 3 to 7 percent annually, says Rogé.) Target-term trusts tend to pay a bit more than bonds of like maturity and quality, because of their complex investment strategies.

"You're looking at a 9, 10, or 11 percent pretax total return, which you can pretty much forecast," Rogé says. "That makes target-term trusts a good replacement for municipal bonds that pay 4 percent."

One trust that Rogé recommends to clients is BlackRock Strategic Term Trust. "Its management team has been successful in bringing the trusts in on target," he says. Moreover, the managers invest their own money in the trust, he says.

Although Rogé claims that he has had excellent results with target-term trusts, be aware that when such a trust matures, it could return less than the forecast total return. Ask your financial adviser to clarify the worst-case scenario before buying target-term trusts.

Once you've executed your cash plan, keep an eye on it. You don't want to keep $100,000 in a money-market fund if you have no immediate plans for it. Shift it to more aggressive investments, instead. You'll also want to shop around periodically, to see whether other institutions are offering better yields.

"People tend to overlook the simple things, like strategic use of cash, but it can add a lot," says Al Zdenek. "Over time, even an extra 1 or 2 percent can add a tremendous amount of return to portfolio, for very little risk."

Taxable or tax-exempt instruments?

One choice you face as you shop for short-term cash vehicles is whether to go with tax-exempt or taxable investments.

This table compares fully tax-exempt yields with those subject to federal (but not state) income taxes. Find a tax-exempt yield in the first column, then check the row under your tax bracket to see the taxable equivalent. In the 28 percent tax bracket, for example, a tax-exempt 5 percent yield is equivalent to a taxable 6.9 percent.

For an expanded version of this table, as well as one that lets you calculate taxable equivalents if your earnings are subject to both federal and state taxes, visit www.ifds.com/tevtax01.htm.