How to Squeeze More Income Out of Your Cash Reserves

The Federal Reserve is tapering their bond-buying program, but interest rates remain low. In fact, since the beginning of this year, the ten year Treasury note has declined from roughly 3% to 2.54% (5-21-14).

Retirees and savers are frustrated. Since 2008 CD rates have plummeted. Since emergency cash reserves and money that you will be spending in the next 2-3 years should be kept in a cash or cash equivalent account, what is the best way to maximize your yield?

The highest yields for cash can be found at online banks and credit unions such as GE Capital, Ally, ING, etc. The reason these rates are significantly higher than local banks is that these companies do not have to pay for infrastructure (bank buildings) or labor (tellers). Transactions and customer interaction is done primarily online. Since most online savings accounts are yielding more than three times the rate of local banks, the extra inconvenience of setting up an online account is generally worth it. For example, most local banks are offering yields on their savings accounts of up to 0.2%. As of 5-21-14, you could find an online savings accounts yielding 0.95%. If you had $100,000 in savings, switching to an online savings account would put an extra $750 in your pocket. Before you open a savings account online make sure to check if they have any restrictions on monthly transactions and make sure the bank has safe ratings.

Longer term cash needs-CDs and bond funds

Certificates of deposit (CDs) may be a good savings vehicle for the balance of your emergency reserve or additional cash needs over the next 2 to 4 years. In this extremely low-interest rate environment, it may not make sense to purchase long-term CDS unless they have a low early withdrawal penalty. Although we can never know for certain where rates will end up in the future, chances are more likely that rates will be higher than they are today. Current 2 year CD rates are averaging around 1.25%, 3-year rates are 1.4%, and 4 year are 1.7%. If you lock in a 4 year CD at 1.7% and rates rise to 2% in the next year, you won’t be happy. Consider putting the cash you need for the next 2-3 years in a savings account with the balance of your necessary reserves in a 3 year CD. Alternatively, you could ladder any reserves needed in year 2 and 3 in CDs, but the small yield differential and prospect of raising rates may not make that extra work worthwhile.

For those investors who are still not happy with the interest rates on CDs and online savings accounts, another place to invest would be short to intermediate-term bond funds; however, bond funds have drawbacks. They are not FDIC insured, and the investment will experience a loss in principal when interest rates rise. If you want to use bond funds, choose high-quality funds with no more than a 4-year duration.

Higher yields can be found with longer term or lower quality bond funds, but these funds tend to act like stocks when markets drop. For now, CDs seem to be preferable to the bond funds as many of the shorter term higher-quality funds have lower yields than CDs.

A big caveat is that investors in the highest tax brackets may want to skew more of their reserves into municipal bond funds since a 3.8% surcharge is assessed in addition to their applicable tax rate on all interest and dividends they receive from taxable bond funds, CDs, and savings accounts. A limited term or intermediate term tax-exempt bond fund may be desired, in addition to some FDIC insured savings.

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