The Wall Street Journalrecently published an article titled, “Wealth Management Has a $3 Trillion Problem: Investors Are Keeping Too Much Cash.”
According to the Investment Company Institute, investors now hold approximately $3.1 trillion in retail money-market funds, a near-record amount.
There are good reasons to hold cash. Money needed for emergencies, upcoming purchases, or other short-term goals should generally remain readily available. The problem is not holding cash. The problem is holding more cash than you need without understanding what it is actually earning.
The Same Two Silent Thieves
In my recent article, “The Two Silent Thieves: How Inflation and Taxes Can Erode the Real Return of a ‘Safe’ CD,” I explained how taxes and inflation can reduce the real return of a CD.
The same principle applies to taxable money-market funds.
The Wall Street Journal article reports that the average money-market yield is 3.49%. That is the advertised yield, not necessarily what an investor keeps.
For example, an investor in the 22% federal income tax bracket would retain approximately 2.72% after federal taxes, before considering state taxes. Inflation may then reduce the purchasing power of that return even further.
At the end of the year, the investor may have more dollars but still be able to buy less with them.
That does not automatically make the money-market fund a poor choice. It may be entirely appropriate for money that needs to remain stable and accessible. The important question is whether all the money being held there has a short-term purpose.
What Are the Alternatives?
The Wall Street Journal article mentions investment-grade bonds as one possible alternative. These bonds may offer attractive yields, but their interest is generally taxable, and their prices may decline if interest rates rise or if they are sold before maturity.
The article also discusses buffered exchange-traded funds, or ETFs. These investments may provide limited protection against certain market losses, but that protection is not complete. Their returns depend on the market and the specific terms of the fund. In some circumstances, leaving the money in a money-market fund could produce a better result.
For investors in higher tax brackets, municipal bonds may also deserve consideration.
Interest from many municipal bonds is generally exempt from federal income tax. Depending on the investor’s residence and the bond’s issuer, the interest may also receive favorable state or local tax treatment. This can result in a tax-equivalent yield that compares favorably with taxable alternatives.
Municipal bonds are not risk-free. Investors should consider:
Credit quality
Interest-rate risk
Maturity
Call provisions
Liquidity
The possibility of losing principal if a bond is sold before maturity
Fees and expenses
Possible Alternative Minimum Tax implications
Municipal-bond funds can also rise or fall in value and do not guarantee the return of principal at a particular date.
Know What Your Cash Is Supposed to Accomplish
The question is not whether cash, CDs, taxable bonds, municipal bonds, or buffered ETFs are universally better than one another. Each serves a different purpose and carries different risks.
The better questions are:
How much cash do I need for emergencies and short-term expenses?
How much of my money is intended for longer-term goals?
What am I earning after taxes and inflation?
Am I being compensated for the risks I am taking?
Does my current strategy fit my goals, time horizon, liquidity needs, and tolerance for risk?
If you have not considered municipal bonds or other tax-aware investment options, it may be worth having a conversation. If you would like to discuss your cash holdings and the alternatives available for your consideration, please contact me. My goal is to help you understand the choices, risks, and tax considerations before you make a decision.
Disclaimer: This article is provided for educational purposes only and is not individualized investment, tax, legal, or financial advice. Money-market mutual funds are securities and are not deposits insured by the FDIC. CDs and eligible money-market deposit accounts held at an FDIC-insured bank may qualify for FDIC insurance, subject to applicable limits and ownership rules. Municipal bonds and municipal-bond funds are subject to credit, interest-rate, call, liquidity, market, and inflation risks. Interest from municipal bonds is not necessarily exempt from all federal, state, or local taxes, and interest from certain bonds may be subject to the Alternative Minimum Tax. Buffered ETFs involve investment risk, do not provide complete downside protection, and may limit potential gains. Investors should review all relevant offering documents and consult qualified financial and tax professionals before investing.