The Best Short-Term Investments
I used to love trying to build houses of playing cards as a kid. But I never got past the second or third story before I breathed on it wrong and the whole thing came tumbling down. Trying to get the most out of the savings that you’re scraping together can be a little like that if you’re not careful. If you get too aggressive or try to earn too much on it, you’ll expose yourself to unnecessary risk. So here’s the punch line: keep this money far away from the stock market or anything else where you can lose your principal.
The stock market is absolutely wonderful for long-term investments, returning an average of 10 percent per year since before the Great Depression. But that nice and neat 10 percent average is actually comprised of some ho-hum flat years, some incredible years, and some years that make stockbrokers jump out of windows. Because it’ll always be easier for you to do better than a flat year in the stock market, and a 20 to 30 percent down year is definitely not something you should toy with, that really leaves you choosing between different fixed-income investments as a parking place for your savings.
DEFINITION
Principal refers to the original amount someone invests in something. The safest investments have no principal risk associated with them. Typically, these are fixed-income investments, whose return comes primarily from the fixed amount of interest they pay, as opposed to the value of the principal going up.
As any owner of junk bonds can tell you, though, not all fixed-income investments are created equal. In addition to making sure you get a good interest rate on whatever investment you park your money in, you need to ensure that the entity you’re “loaning” your money to is going to stick around long enough to pay you your interest and principal. This means that loaning your money to the U.S. government at 3 percent is probably a lot smarter than loaning it to your third cousin Earl at 8 percent, even though the rate from the government isn’t that great.
Money Market and Savings Accounts
Depending on the movement of interest rates at the time of you reading this book, money market and savings accounts might be one of the best short-term places to park your money, or one of the worst. As with every investment listed in this section, you’ll need to compare both the rates you can earn on these accounts as well as their safety.
Safety, you ask? Aren’t savings and money market accounts insured by the government?
Yes and no. Generally, savings accounts are FDIC-insured up to $250,000, which means that the U.S. government ultimately backs both your principal and the interest to which you’re entitled. Money market accounts, on the other hand, usually have no guarantees associated with them, even though most professionals (including myself) consider them very safe. However, money market accounts can hypothetically lose some of their value, even if the money market fund invests only in government bonds. It’s highly unlikely, but it’s possible.
DEFINITION
FDIC insurance provides a guarantee to depositors at participating banks that their deposits are protected even if the bank goes out of business. It’s important to note that brokerage firms are not covered by the FDIC (Federal Deposit Insurance Corporation), but by the SIPC (Securities Investor Protection Corporation), which is not directly backed by the government.
The primary advantage of using either a money market or savings account is that the money is highly liquid; in other words, it’s easily accessible. These accounts are essentially bank accounts that pay interest, without any commitment to leave your money there for any length of time.
You should probably use a savings or money market account if:
• Rates on these accounts are the same or greater than CDs or Treasury instruments.
• You’re going to college in less than a year.
• You’re starting with a relatively small amount and adding to it on a regular basis.
• You cannot qualify for a prepaid tuition plan or your state’s plan gives you limited flexibility on where you can attend school.
Certificates of Deposit
One of the classic trade-offs with fixed-income investing is that, generally, the longer you are willing to commit to not touching your money, the higher the interest rate you will earn. There are, of course, times where this is not true, but they are rare.
Certificates of deposit (CDs) are essentially a commitment on your part to a bank to deposit your money for a certain amount of time in exchange for a preset rate of interest. Typically, if you try to access your money prior to the maturity date of the CD, you’ll pay a penalty or forfeit some of your interest.
CDs issued by a FDIC-insured bank are also FDIC-insured, so generally you have no risk to your nest egg if you buy them straight from a bank. However, some CDs are not FDIC-insured and are often sold by the fixed-income departments of Wall Street brokerages. You should avoid these for safety reasons, as well as another type of brokerage CD called “secondary CD’s,” which can be an accounting nightmare at tax time.
You should consider using a CD to park your short-term savings if:
• The CD is FDIC-insured.
• The rates are at least one-quarter of 1 percent higher than money market and savings account rates.
• There is no chance that you’ll need to access that money prior to the maturity date of the CD.
• Their rates are below 4 to 5 percent and you’re not eligible for a prepaid tuition plan run by your state.
• Their rates are above 4 to 5 percent, if you’re eligible for a prepaid tuition plan run by your state.
U.S. Treasury Bonds
If you’re looking for a simple place to park the money and aren’t worried about grinding out an extra quarter of a percent on your savings, then government bonds probably aren’t for you. But if you have $1,000 or more—especially if you’re sitting on $10,000 or more—you should give U.S. Treasury bonds a look.
WORLD WIDE WISDOM
The best place to get any type of government-issued bond, note, or bill is TreasuryDirect.gov. This is the official site of the U.S. Treasury, and it lets you purchase bonds with no fee and much smaller minimums than if you do so through secondary institutions or brokerage houses. That translates to a higher rate of return for you.
Several classes of government bonds are available, only a few of which are attractive to someone saving for the short-term:
• Treasury bills (T-Bills)—The shortest term of all government bonds, T-Bills can be bought to mature in 4, 13, 26, or 52 weeks. They don’t actually pay interest separately but are issued at a discount to their maturity values. For example, a T-Bill that matures at $100 might be purchased for $97 today. That $3 increase at maturity represents the interest you’ve earned.
• Treasury notes—These are issued in increments as short as 2 years and as long as 10 years. They pay interest every 6 months, which most people deposit into a money market account until they have enough to buy another.
• Zero coupon bonds—Wall Street brokerage firms usually offer a large selection of quasi-Treasury bonds, known by funky names such as STRIPS, TINTS, or TIGERS. Though the discussion of how these bonds came to be is beyond the scope of this book, you should feel comfortable buying these as well, as long as they are based on U.S. Treasury securities. In a nutshell, these zero coupon bonds are issued at a discount compared to what they’ll eventually pay out when they mature. Your return equals the difference between what you paid for and what it matures at, without the hassle of having to invest the small interest payments you might receive from things like a CD or other types of bonds.
One thing that makes U.S. Treasury bills and notes attractive is that their interest is not taxed by individual U.S. states as income tax. That means that a U.S. Treasury note paying 5 percent would actually leave you with a little more after taxes than a CD paying 5 percent because the interest on the CD is fully taxable by your state.
To decide if a CD or savings account is better than a government-issued bill, you need to do a simple computation known as the tax-equivalent yield (TEY). The TEY essentially shows you what a fully taxable CD or savings account would have to earn to beat the tax-advantaged government bond.
DEFINITION
The tax-equivalent yield (TEY) shows what a fully taxable bond would have to earn to have the same after-tax yield as a bond that is not taxed by either your federal or state government.
To calculate the TEY, you divide the interest rate on a government bond by 1 minus your state income tax rate. For example, if a U.S. Treasury note was paying 5 percent and you expect to be taxed 8 percent by your state, you would calculate the TEY as .05/(1.00 - .08). This yields a TEY of 5.43 percent, meaning that if a CD or money market account was not paying above 5.43 percent, you’d be better off after taxes to stick with the U.S. Treasury note.
Short-term Treasury bills and notes are your best bet when:
• You have at least 3 to 6 months until you need the money.
• The other options can’t beat the TEY on U.S. Treasury instruments, taking into account your state’s income tax bracket.
• Their rates are below 4 to 5 percent and you’re not eligible for a prepaid tuition plan run by your state.
• Their rates are above 4 to 5 percent, if you’re eligible for a prepaid tuition plan run by your state.
Section 529 Prepaid Tuition Accounts
I saved the best (and my favorite) short-term savings option for the last. Unfortunately, not everyone will be able to use Section 529 Prepaid Tuition accounts for one reason or another. Specifically, these accounts must usually be opened no later than age 18, are only offered by some states, and might have minimum amounts of tuition that must be purchased (deposited).
These plans allow you to prepay tuition now, at today’s rates, for your future education. Because tuition costs have been rising steadily at a rate of at least 4 to 5 percent per year, this will generally outperform most other short-term fixed income investments in most economies. Sweetening the pot is the fact that many states actually give income tax deductions or credits for contributing money to these plans as well.
Section 529 Prepaid Tuition plans are ideal when:
• A student is under age 18 with at least one year to go until the money is needed.
• Interest rates on other fixed incomes are under 4 to 5 percent.
• You live in a state where an income tax deduction or credit is offered for contributing to Section 529 plans.
• Your state’s Section 529 plan allows students to go out of state or there is a high likelihood they’ll go to school in state.
FLUNK-PROOF FINANCES
Due to the hoops that you have to jump through and the costs you might incur to liquidate certain types of investments, parents with less than a year or two until college should probably avoid sticking college funds in life insurance, annuities, retirement accounts, gold, collectibles, or ownership in a business.
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