Low-Risk Places to Keep Cash

Your emergency fund, the down payment you will need next year, the cash between paychecks: this money cannot be put at risk in the stock market, but leaving it in an account that pays almost nothing quietly costs you every year. Between those two mistakes is a set of low-risk options: high-yield savings, Treasury bills, I bonds and TIPS, certificates of deposit, and money market funds. Each protects your principal in a different way and gives up something different in exchange. This chapter explains what "low risk" really means, how each option works, how each is taxed, and how to match the option to what the money is for.

What "low risk" protects, and what it does not

Low-risk does not mean no risk. It means one kind of risk is removed and others remain.

The trade is deliberate: you accept lower long-run returns in exchange for knowing the money will be there. That is the right trade for money you will need within a few years, and the wrong one for money you will not touch for decades. It also helps to judge any rate against inflation. A 4% yield with 3% inflation grows your buying power by only about 1% a year; the real return calculator does that arithmetic for any pair of rates.

High-yield savings and money market accounts

A savings account at a bank or credit union is the simplest home for cash you may need at short notice. Banks lend deposits out at higher rates and pay you part of the difference; online banks, with no branches to run, usually pay noticeably more than large branch-based banks.

Deposits are insured by the FDIC at banks, and by the NCUA at federally insured credit unions, up to $250,000 per depositor, per institution, for each ownership category (individual, joint, certain retirement accounts and so on). Above that amount, spread money across institutions or ownership categories. A bank's money market account is a savings account with a different name and is insured the same way.

The cost of leaving cash in a low-paying account adds up. Here is the same balance held for five years at two rates.

At 4.0%, $20,000 earns about $4,333 in interest over 5 years. At 0.5%, it earns about $505. Nothing about the risk changed; only the account did. Savings rates move with the Federal Reserve's policy rate, so compare them again whenever rates change.

Treasury bills, I bonds and TIPS

Treasury securities are loans to the US government, backed by its full faith and credit. Their interest is taxed federally but is exempt from state and local income tax, which matters most in high-tax states.

Treasury bills mature in a year or less, in terms from four weeks to fifty-two weeks. You buy them at a discount and receive the full face value at maturity; the difference is your interest. You can buy them at auction through TreasuryDirect or through a brokerage account, and roll them over automatically. Because their yield is free of state tax, a bill can beat a savings account with a higher quoted rate once state tax is counted. The savings vs T-bill after-tax calculator compares the two for your tax rates.

I bonds are savings bonds whose rate has two parts: a fixed rate set when you buy, which never changes, and an inflation rate that resets every six months from the consumer price index. You can buy up to $10,000 in electronic I bonds per person each calendar year, only through TreasuryDirect. They cannot be cashed in during the first twelve months, and cashing in before five years costs the last three months of interest. They suit money you want protected from inflation and will not need for at least a year.

TIPS (Treasury Inflation-Protected Securities) adjust their principal with inflation, and the fixed interest rate is paid on the adjusted principal. At maturity you receive the adjusted principal or the original amount, whichever is larger. They have no purchase limit and can be bought through a brokerage. Two points to know: the yearly inflation increase to principal is taxable federally in the year it happens, even though you do not receive it until maturity, which is why TIPS are often held in retirement accounts; and if you sell before maturity, the price depends on market rates and can be lower than you paid.

Certificates of deposit and CD ladders

A CD pays a fixed rate for a fixed term, from a few months to several years, in exchange for an early-withdrawal penalty if you take the money out before the term ends. Bank CDs carry the same deposit insurance as savings accounts. CDs bought through a brokerage can usually be sold before maturity instead of paying a penalty, but at the market price, which falls when rates rise.

CDs make the most sense when you know when you will need the money, and when you want to lock in a rate you expect to fall. If you are unsure which way rates will go, a CD ladder spreads the risk. Split the money into equal parts and buy CDs with staggered terms, for example a fifth each at three, six, nine, twelve and fifteen months. Each time one matures, either use it or buy a new fifteen-month CD. After the first year, every rung earns the longer-term rate, and a fifth of the money still becomes available every three months.

Money market funds

A money market fund is an investment fund, not a bank account. It holds very short-term debt and aims to keep its share price at one dollar while paying out the interest. It is not covered by FDIC insurance, though the largest funds have a long record of stability. Government money market funds, which hold almost entirely Treasury and other government securities, carry the least credit risk; part of their income may be exempt from state tax, depending on what they hold and where you live. Prime funds also hold corporate debt and can pay slightly more for slightly more risk. Brokerages often use a money market fund as the default home for uninvested cash, so check which one yours uses and what it pays.

Matching the option to the job