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Most of us think of the money we carry in our wallets as cash, and
that’s it. Cash, though, has a broader definition than just the coins
and bills we use to pay for goods. It is also the type of investment
characterized by a high level of liquidity and little to no risk to your
original investment.
Generally, cash investments are short-term, interest-bearing securities
that offer investors the opportunity to collect a specified interest
rate, keep a high level of security and maintain liquidity with their
money. The most commonly used cash investments are bank savings
accounts, certificates of deposits (CDs), and money market funds.
Some employer-sponsored retirement plans may offer guaranteed
investment contracts, which are another form of cash investments.
Cash investments are best used for emergency funds. This is
money you want to have some return on, but if you needed it, you
could have it in hand very quickly. This may also be money that you
would like to invest in the near future, but haven’t quite decided
which investments are right for you. Because these investments are
highly liquid, they tend to offer lower returns than other investments
might. Most of these investments also don’t have any surrender
charges for withdrawing the money.
The Federal Deposit Insurance Corporation insures passbook
accounts, money market deposit accounts, and CDs that are issued by
its member banks and savings and loan institutions up to a maximum
of $100,000. For cash investments offered by credit unions, there is a
federal deposit insurance agency that differs from the FDIC.
Any interest earned on savings accounts or money market
deposit accounts is fully taxable for federal income tax purposes.
Savings Accounts
Savings accounts, or passbook accounts, are found at any bank, credit
union, or savings and loan institution. Because they are extremely liquid,
they are characterized as having extremely low interest rates. Passbook
accounts also tend not to have check-writing privileges. Most
banks also offer interest-bearing checking accounts. However, the
interest on these accounts tends to be less than that on savings accounts
and there may be quite high minimum balances required in order to
qualify to receive interest. Any interest received on either a savings
account or a checking account is taxed as ordinary income.
Money Market Deposit Accounts
Money market deposit accounts, which differ from money market
mutual funds, typically offer a higher rate of interest than a savings
account would. However, there is usually a minimum deposit, and the
institution may charge a fee if your balance falls below the required
minimum. Money market deposit accounts are federally insured,
while money market mutual funds are not. The interest rates for these
accounts tend to be less than they would be on other, longer-term,
less liquid accounts, such as CDs. There is typically no surrender
charge for withdrawing your money. Interest received on these
accounts is taxed as ordinary income.
Money Market Mutual Funds
These are among the most popular types of investments today.
Money market funds invest in Treasury bills, jumbo CDs (CDs that
have a certain minimum amount, such as $100,000), commercial
paper, and other short-term, interest-bearing securities. The securities
held by money market funds tend to have a maturity between 30
and 90 days. Generally, the interest earned on money market funds is
greater than that earned on savings and money market deposit
accounts.
Some money market funds hold short-term municipal securities,
which would entitle the money market fund investor to tax-exempt
interest. Both taxable and tax-exempt funds usually offer check writing
and telephone-transfer (to another fund within the same fund
family) privileges.
Money market funds may be offered through stock brokerage
firms and mutual fund companies. Neither the Federal Deposit Insurance
Corporation nor any other government agency guarantees an
investment in a money market fund.
Certificates of Deposit
CDs are deposits made to a bank or savings and loan institution for a
specific period of time, usually a minimum of three to six months all
the way up to 10 years. They are insured by the FDIC and offer a
fixed rate of return and fixed principal value. While these are cash
investments, they aren’t as liquid as a savings account or a money
market fund. Because of that, they are known to pay a higher interest
rate. Typically, CDs offer tiered interest rates: the more money you
put in, the higher the interest rate will be. This also works for how-
ever long you invest your money. Generally, the longer your money
is in a CD, the better an interest rate you will receive. You may also
be able to purchase CDs that have variable interest rates. Since your
money will be tied up for a specified time period, there may be a surrender
charge for redeeming the CD early.
Banks, credit unions, and savings and loan institutions aren’t the
only place to purchase CDs. This will help if you decide you want to
invest in one because you can shop around for the best interest rate.
Many stock brokerage houses sell CDs that were issued by banks or
credit unions. Through brokered CDs, you may have access to a secondary
market for your CD, which could negate the possible surrender
charge. They may also offer slightly higher interest rates.
Because you lock in your interest rate when you initially invest
your money in a CD, you may be subject to interest rate risk. When
the interest rate begins to rise, the corresponding rates on CDs will
also rise. By locking in your rate earlier, you will be earning less than
if you were earning the current rate. Plus, you wouldn’t be able to
pull your money out to reinvest at a higher rate without incurring
some type of early withdrawal penalty. Interest paid on CDs is fully
taxable for federal and state income taxes. However, the surrender
penalty may be deductible from your gross income for tax purposes.
There are also market-linked CDs, which are tied to an equity
index, like the S&P 500 stock index. These CDs have an FDICguaranteed
principal, but their return is based on the market’s
actions, provided that the investor has held the CD until maturity.
For example, if you purchased a market-linked CD (MLD) for
$5000 and the applicable market index increased, at maturity you
would receive your principal of $5000 plus a return based on the
index’s appreciation. However, should the market go down, you
wouldn’t receive any return on your money. You would simply
receive your original investment of $5000 back. If you were to
redeem or sell the MLD prior to maturity, chances are you wouldn’t
receive 100 percent of your principal.
For tax purposes, the gain on the investment is taxed annually as
ordinary income even though the investor sees no current interest
income from the MLD. This is why MLDs are usually held in taxqualified
plans.
Commercial Paper
Commercial paper securities are short-term promissory notes issued
time to time by major corporations. They typically have maturities
from 30 to 270 days, and fairly high minimum amounts like $10,000.
The only asset securing these investments is the financial strength of
the issuing company. Historically, this has been quite good. Commercial
paper may be purchased through broker/dealers and commercial
banks. These are considered money market investments
because they are shorter-term, high quality securities. Most often,
commercial paper is purchased by money market mutual funds and
other lenders that are interested in short-term, liquid investments.
The interest and any gain on commercial paper are fully taxable.
Guaranteed Investment Contracts
Within many employer-sponsored retirement accounts, such as
401(k)s, guaranteed investment contracts (GICs) are an option. GICs
are fixed-interest-bearing contracts generally issued by insurance
companies. Since they are purchased through retirement plans, they
are, in essence, a contract between the employer and the issuing company.
The issuing company accepts funds for investment for a specific
period of time during which the money will earn a guaranteed
interest rate or rates, and guarantees both the GIC’s principal and
interest for the specified time period. The participating employee
may then elect to invest all or some of their money in the plan’s fixedinterest
account, to the extent that the plan allows. It’s through the
GIC that the plan provides for the fixed-interest account. The
employee’s money may stay in this account for as long as the
employee wishes, or for as long as the GIC lasts. Typically, GICs
have maturation periods of three to five years. At maturity, the
employer and issuing company may enter into a new GIC. This new
GIC may have a different interest rate, given the current interest rates
and market conditions. Representative current GIC interest rates for
certain amounts and time periods may be found in the financial
pages of some publications.
GICs are backed by the issuing company. Therefore, when considering
investing your money through a GIC, you should take a look
at the financial soundness of the issuer. There are state guaranty
funds that cover insurance companies, but there is no federal government
insurance covering GICs that would be comparable to the
FDIC’s insuring bank deposits. While they aren’t as safe as federal
insurance protection, your principal will remain safe even when
interest rates rise, barring default by the issuing company. |
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