It’s hard to quantify the unbelievable change the world has experienced due to the coronavirus. Most significant are changes in the health and safety of the worlds’ population, but falling right behind is the devastation to the world economy. In response the Federal Reserve board (Fed) has taken unprecedented steps to slash interest rates and support various aspects of the bond market to provide liquidity for the US markets. Many have said this may be a generational opportunity to invest in the stock market, but that comes with significant volatility. For some looking to use money within the next few months or years the question of where to park money has become increasingly challenging.
That’s simply because all the changes the Fed has made have a significant impact on savers.
Lost are the passive streams of income that used to come from holding cash in an interest-bearing savings account.
Within this context, we will look to see where there is potential opportunity to hold cash that may be needed in the short-term. In particular, we consider the possibilities for physicians and dual income households that may fall into higher federal tax brackets.
Traditional Savings Accounts
Traditional savings accounts are offering interest rates close to zero in the current climate. This form of an account offers liquidity and typically has no minimums, but you also get a commensurately low interest rate. All income is subject to ordinary income tax, but with such a low interest rate, taxes won’t be much of an issue.
High-Yield Savings and Money Market Accounts
Shopping around to various regional and national banks may identify a rate significantly greater than what you’re receiving right now if you’re looking at high-yield savings accounts. As of the time of writing this article, interest rates in these types of accounts at major national and regional banks vary between 1.30%-1.70%. Bankrate.com can help identify some of the currently available rates. While these rates are much better than traditional savings accounts they too have fallen significantly from where they were just a month ago. These accounts remain liquid, but often require some minimum balance maintained either within the account or across linked accounts at the same bank. However, the interest is subject to ordinary income tax. At the second highest tax tier this means you keep 65% (35% Rate) of earnings, meaning the 1.70% yield becomes effectively 1.11% in after-tax yield.
Bonds as a general investment class have become even more accessible than they used to be due to various exchange traded funds (ETFs) and bond mutual funds that allow anyone with an investment account to become a bondholder. One way to think of bonds is as a mortgage. Instead of you borrowing money from a bank and making mortgage payments, a corporation or municipality/government borrows from the bondholder (you) and makes coupon payments (interest payments) to you and pays off the loan entirely when the bond matures.
Bonds have a term until they mature which, similar to a mortgage, identifies the time horizon until the loan is due. Not all bonds are the same as there are different risk levels associated with each: treasuries (government bonds) have the lowest risk of defaulting, while investment grade bonds are slightly riskier. Junk/high yield bonds are the most risky and have the greatest risk of default. The latter two tiers apply to municipal and corporate bonds.
Treasuries are bonds issued by the government and are considered the safest category of bonds. You can purchase these just like you would purchase a stock in an investment account but another effective way to purchase them is through a bond mutual fund through Vanguard, Fidelity and others. As an example, one well-regarded fund is the VUSTX from Vanguard based on US News and World Reports rankings. While there is significant liquidity, there is some risk to price fluctuations, and the yield (1.99% for VUSTX) is lower than corporate bonds. Once again the tax rate is of normal income.
iShares (LQD) and Vanguard (BLV) has some excellent corporate bond funds that are traded as ETFs that allow you to benefit from these payments without the risk of choosing an individual corporation. Since there are hundreds of bonds in the ETF, any single bond or company going bankrupt has minimal impact on the entire fund. For example, one of the most popular ETFs is the LQD which invests in investment-grade corporate bonds. As of the time of this writing it yields about 3.20%. Be aware there is greater risk than keeping money in cash as the value of the ETF can go up or down while you hold it, which is why the yield is greater than safer money market funds. Again assuming the second highest tax tier this generates an after-tax yield of 2.08%.
When municipalities are the borrower there are additional advantages of tax savings, because the income is considered tax-free. Because of this tax-protected status these bonds often have a lower yield than their corporate counterparts, but the tax benefit may still outweigh the lower yield. For states with income tax you typically have to choose municipal bonds to invest within your state to achieve tax-free status on both state and federal taxes. MUNI is the ticker symbol for a PIMCO managed actively traded which yields 2.38%. When compared to the LQD in the corporate bond world, this after-tax yield remains substantially higher.
A back of the envelope calculation shows that if you are in the 32% tax bracket or higher, there may be yield advantages when looking at tax-free municipal bonds.
Moreover, the advantage increases as your tax bracket increases. Finally, all of these calculations were done without the additional tax advantages that come with elimination of state income tax on these earnings. However, you must remember to choose a municipal bond ETF or fund that applies to your specific state if you want to redeem these additional benefits.
So while stashing cash under your mattress is still an option, it’s worth evaluating all the possibilities available to you to maximize passive income while you wait to deploy your cash.
- Remaining smart about where to park your cash in an uncertain environment can lead to improved passive income.
- Evaluating different risk levels when evaluating bonds is important as higher yield typically comes with higher risk.
- Critically, understanding the net income after taxes is important to maximizing your returns especially for higher income earners in the top three tax tiers.