Option for holding cash and cash equivalents

Let’s talk about cash…and cash equivalents.

The word “cash” doesn’t just mean physical bills that you keep in a wallet or under your mattress. It also means the electronic version of cash, which is deposited, withdrawn, transferred, and/or spent without seeing or touching any physical bills. Think about all of the electronic cash transactions do you with online banking, mobile check deposits, Venmo transfers, ACH transfers between your bank and brokerage account, and so forth.

But what about when you want or need to do something with your cash other than keep it in a coffee can in your house, or keep it electronically in a bank account? Then you can consider putting the money into cash equivalents; things that aren’t exactly cash, but share some important characteristics with cash such as they 1) have no (or negligible) chance of a decline in principal value, 2) earn a fixed or stable rate of interest and 3) are “liquid” and therefore quickly and easily accessible when needed.

Each of the different cash equivalents functions a bit differently, and they all have their own potential pros and cons, as I’ll be covering here. And I’ll also briefly touch on the taxability of each. Specifically, I’ll be assuming that you’re holding your cash or cash equivalents in the normal “non-qualified” world; in a regular bank account, brokerage account, etc. However, you can also hold cash and cash equivalents in “qualified” accounts such as in a pre-tax IRA or 401(k), a Roth IRA or Roth 401(k), a Health Savings Account or “HSA,” or a 529 college savings account. While the taxability of holding cash and cash equivalents in qualified accounts is different than I’ll be addressing in this article, the rest of the function and characteristics of cash and cash equivalents is no different in qualified accounts vs non-qualified accounts.

Before getting into the different options, I want to first briefly summarize some typical reasons why someone might want to hold cash and cash equivalents.

Holding cash and cash equivalents is generally for when you have essentially zero willingness or ability to risk losing any of your principal, and you’re going to want or need to use the money soon.

For example, you’re going to need money to pay for your normal upcoming day-to-day bills and living expenses over the next few months. As such, you probably don’t want to have that money invested in something risky such that when it comes time to need some of it to pay your mortgage in a few weeks, you don’t want to risk having to sell an investment that might have dropped a lot in value. Similarly, you don’t want the money to be tied up in something “illiquid” that won’t let you quickly and easily get the money when needed, thereby putting you at risk of not paying your bills on time.

Even above and beyond normal monthly bills, it’s usually good practice to keep some kind of emergency fund readily available to cover big unforeseen expenses, like needing a new HVAC system in your house. Going back to the same premise as above, when the time comes to need $20k to give the contractor, you don’t want to be forced to sell out of investments that might currently be down in value. It would be better to have a pool of safe and stable cash or cash equivalents to take from, where that money isn’t at the risk of the markets, and is readily available to you whenever needed.

And then there are other potential one-off bigger things that might warrant holding a lot of money in safe and stable principal-protected things that won’t decline in value. Such as if you know you’re going to be buying a house in a few months and need $300,000 of cash at closing for the downpayment. If you were to put that $300,000 into the stock market today, it’s possible it could drop a lot between now and then.

For example, maybe in a few months when you need $300,000 for the house closing, that money is then only worth $250,000 due to a nasty stock market decline. That would be a problem and, in a worst-case scenario, could potentially mean you’re not able to close on buying the house. In this example, you want to ensure that the $300,000 you have today is still going to be at least $300,000 when you need it in a few months. Hence you likely want to keep it in something principal-protected, so it doesn’t decline in value. AND you need it to be liquid in a few months when you need to use it for the house closing. In other words, don’t put it in something that guarantees you won’t lose any value BUT makes you lock the money up for a year.

For retirees living off of their investable assets, having cash or cash equivalents could be one way to earmark and cover projected cash flow needs not just for the upcoming next few months, but potentially the next few years. Some folks prefer to know their next few years of expense needs are earmarked in something safe, liquid and not at risk of any potential declines in value.

There is no universally right view or approach on how much cash is the correct amount of cash to have. I work with some folks where they want seven years of projected expenses in cash and cash equivalents. I work with other folks who don’t want to hold any more cash or cash equivalents than a couple months of routine expenses, plus a small emergency fund. And then other folks are somewhere in between on that spectrum. Different strokes for different folks (and different risk tolerances and risk capacities!)

The balancing act with figuring out how much cash to hold is trying to keep enough to cover potential near-term money needs, but not have so much cash that your overall asset mix is too heavy into cash and the relatively low rates of interest it earns. In other words, over the long-term, the returns you get on “investing” in cash aren’t likely to keep up with inflation, let alone provide any sort of meaningful growth beyond inflation. Whereas other assets such as stock funds, for example, are more likely to provide higher long-term returns that not only keep up with inflation but outpace it. But, the potential short-term volatility and risk of stock funds doesn’t make them suitable to use for money you plan on needing to use in the near-term (at least not without knowingly gambling, for lack of a better word).

With this said, the goal is trying to find the right balance for you of having enough cash to meet your upcoming money needs and to allow you sleep well at night, but not have so much that the low returns you’ll get on it will potentially be a drag on your long-term finances and detrimental to your bigger picture financial plan. In other words, the indirect cost, or “opportunity cost,” of holding too much cash is that it’s taking away from you having higher exposure to other asset types that are more likely to perform better over the long-term. But what’s the “right” amount of cash for you and your specific situation??? That depends. And is unfortunately a detailed discussion beyond the scope of this article.

Okay, let’s now finally get into the different types of cash and cash equivalents:

DIFFERENT TYPES OF CASH AND CASH EQUIVALENTS

Physical bills

The most obvious form of cash is actual physical bills (and coins). The pros of keeping a stack of ones, fives, tens, twenties, etc. in your wallet or in your house is that it’s obviously readily available and literally in your hand right when you need it. This is helpful when you’re paying for something somewhere where they only accept actual cash/bills. However, the amount of places that only accept physical cash are pretty few and far between at this point. And, generally speaking, such places aren’t going to be places where you’re going to need thousands of dollars of cash to make your payment. It’s more likely going to be a few bucks, or a few tens of dollars, like at the concession stand at a kid’s baseball game, or at the barbershop or something.

Physical cash also can’t decline in value; a twenty dollar bill will always be worth twenty dollars.

However, loss of buying power due to inflation will slowly make those twenty dollars ultimately less valuable over time as they will have less purchasing power as prices of goods and services steadily increase.

You obviously get no interest on the money you hold in your wallet or under your mattress. If you only keep a few hundred bucks of cash on you or in your house, then you’re not missing out on too much interest and it’s not going to really adversely impact your bigger picture finances. But if you hold tens of thousands of dollars in bills in your house, that’s a different story.

Also, holding too much physical cash could be problematic in that you’ll likely have a hard time actually using it all (outside of illegal or black market activities, but I won’t get into those in this article!). You can’t easily go to a bank and deposit tens of thousand of dollars of cash. Anytime you deposit $10,000 or more in a single day, banks are required to file a special report with the U.S. Financial Crimes Enforcement Network, or FinCEN. This is to help spot and prevent money laundering and other related cash-intensive crimes.

Even if you accumulated your cash from legal activities over many years and have nothing to hide, you still don’t want to be in a position where you’re on any sort of radar relating to government monitoring of potential financial crimes. So avoid that if you can.

And don’t try to avoid the $10,000-per-deposit limit by instead making multiple large deposits of less than $10,000 each. That will still likely get spotted by the banking system and might actually get you even higher up on the monitoring radar than if you did one large deposit. Because it now looks like you’re intentionally trying to avoid triggering any reporting requirement and, by extension, like you’re trying to hide something.

All said and done, having tens of thousands of dollars of cash on hand might be more than you can realistically spend considering your cash expenses will likely be relatively small amounts here and there for things like meals, haircuts, etc.

Also, there are physical risks involved with holding bills. For example, your wallet might get pickpocketed and your cash taken. Or if you keep a lot of cash at home, it’s at risk of theft in the event of a home burglary. Or natural disasters such as a fire or hurricane could lead to you losing most or all the physical bills you keep in your home.

Checking Accounts

The most common place for people to hold cash is a checking account at a bank. Essentially everyone needs a checking account, as it’s the centralized place for the comings and goings of most of someone’s cash transactions.

For example, common sources of income like wages, Social Security, and pensions all generally require electronic deposit - as opposed to paying out physical cash - and therefore need a bank account to go into. Additionally, routine expenses such as mortgages, utilities, and insurance bills typically require electronic payment - instead of physical cash - and therefore require a bank account to get paid from. A checking account is perfect for routine day-to-day cash transactions like all the things mentioned above.

Keeping money in bank accounts like a checking account also helps prevent the risk of physical theft or damage that’s present with keeping physical bills on your person or in your home. Yes, bank buildings can be robbed or damaged in weather events. However, banks have insurance to cover such losses or damages. Also, banks don’t keep much physical cash on hand in their branches anyway. Assume you and 100 customers of your local bank all have $10,000 in your checking accounts. That’s a total of $1,000,000 of electronic money you all collectively have in your accounts. But your local bank definitely doesn’t have anywhere near $1,000,000 in physical bills on hand. As such, even if that branch were to get robbed or destroyed, it’s not like they’re actually losing a million dollars of cash.

Checking accounts should hold enough cash to not risk overdrawing the account. But you ideally don’t want to keep too much money sitting idle in a checking account because there are a handful of potential drawbacks.

One main drawback of checking accounts is the interest rates they pay are usually jokingly small. The national average interest rate for checking accounts continues to be below 0.10% per year. There are some institutions that have high yield checking accounts that might currently pay a few percent interest, especially if you have large balances there. But the purposes of checking accounts isn’t to generate a lot of interest. Instead, it’s to provide the function of being the central hub of people’s comings and goings of day-to-day money. In other words, checking accounts are just to facilitate the routine movement of cash. They’re not intended to be viewed or used as investments, per se.

The other big drawback to checking accounts – or any bank account for that matter – is federal insurance limits on the amount of money you have with any given bank. This insurance is provided by the FDIC, or Federal Deposit Insurance Corporation, and is limited to $250,000 per depositor per bank.

For example, if you have $300,000 in an individual checking account at Bank of America, you’re only insured for $250,000 of it. The other $50,000 is potentially at risk if Bank of America were to become insolvent.

Or, conversely, if you and your spouse have a joint checking account at Bank of America, then each of you has $250,000 of limit such that you two collectively have a $500,000 FDIC insurance limit on your joint checking account. Which means if the example is instead $300,000 in a joint checking account at Bank of America, then all $300,000 is covered by the FDIC insurance.

The rules and nuance around FDIC insurance limits could be a bit tricky, depending on how many accounts you have at each bank, how many are joint vs individual, whether the accounts are owned by a trust, etc. However, the FDIC makes available an online Electronic Deposit Insurance Estimator, or EDIE, calculator, which you can find at https://edie.fdic.gov/calculator.html. You can play around with it and see if your bank accounts exceed FDIC limits.

You might be wondering why FDIC insurance is even needed in the first place. That’s because the money you deposit at a bank, such as in a checking account, is technically no longer yours once you give it to the bank. It’s actually legally the bank’s money at that point. All you have is an IOU from the bank, where they promise to give you back your money when you ask for it. However, because the bank is the legal owner of your money, that means your money is at risk of the bank’s insolvency or misappropriation.

Because capitalism relies on an efficient banking system in which depositors have trust, the federal government provides a backstop, via FDIC insurance, to help give depositors faith that their money won’t just disappear even if the bank runs into significant troubles. BUT, the government puts a limit on how much they’ll backstop; that’s the $250,000 per depositor per bank.

So to wrap up this point, the takeaway is that if you do find yourself wanting or needing to keep a lot of cash in your checking account for whatever reason, try to at least be mindful of the applicable FDIC insurance limit and ideally stay under it.

Savings Accounts

Another form of bank deposit account that’s kind of similar to a checking account is a savings account. On the surface, checking and savings accounts look similar. But there are typically a few key differences.

While checking accounts normally allow an unlimited amount of transactions in the account each month, savings accounts often limit you to no more than a handful of transactions per month; typically five or six.

Checking accounts also give you the ability to write checks against your account (hence the name, “checking” account), whereas savings account generally don’t.

In return for restricting the amount of activity savings accounts can have compared to checking accounts, savings accounts normally pay higher interest rates than checking accounts. This is especially true if you open a “high yield” savings account.

For example, the going rate for most high yield savings accounts is currently around 3.5%, give or take a bit. Whereas normal non-high yield savings accounts might be paying well under 1.0%.

The typical use case for savings accounts is to keep an emergency fund, or other potentially larger amounts of cash you think you might need and want to keep safe and stable, but want to get some more interest than just letting it sit in your checking account.

For example, maybe you keep roughly a month’s worth of routine expenses in your checking account. And then you additionally want to keep an emergency fund of $50,000, just to pick a number. It would generally be better to keep that $50,000 in a high yield savings account as opposed to your checking account. Assuming the savings account is paying 3.5% interest and the checking account is only paying 0.1% interest, you’d get an extra $1,700 in interest for the year on that $50,000.

If you have a savings account at the institution where your checking account is, you can normally do a transfer of funds between the accounts in real-time so that you can make money from the savings account available in your checking account within seconds. If you have the accounts at separate institutions, it typically takes a business day or two to transfer money between the two. So plan accordingly with regards to the timing of when the funds will be available, if needed.

One of the downsides of savings accounts is that the interest rates aren’t fixed or guaranteed; they can and will fluctuate over time. While most high yield savings accounts are currently paying about 3.5% like I said before, we have no idea what their interest rates will be in a year or two or three. For example, when interest rates were super low during the pandemic, high yield savings accounts were paying only like 0.5% I think; maybe less. And then when interest rates shot up in 2022, they were paying over 5.0% if I remember correctly. Now they’re like 3.5%.

So while currently getting 3.5% with no risk of your principal declining in value might be pretty good, it’s possible that rate drops a lot in the next year or two (or maybe it increases a lot…there is no way to know at this point).

The other big downside is again having to pay attention to FDIC insurance limits, and ideally not exceeding them. Again going back to our Bank of America example; let’s assume you’re single and have $50,000 in a checking account there. And then you also have a Bank of America Savings account with $300,000 in it. That’s $350,000 in total that you have with Bank of America. That’s $100,000 in excess of the $250,000 FDIC limit. If Bank of America were to go insolvent overnight, you’re theoretically at risk of not getting all $350,000 back and losing the $100,000 over the insurance limit. Though in reality, if a bank the size of Bank of America were to actually go bust, I have to believe the government would step in and make people whole, even in excess of FDIC limits. Which is what happened when Silicon Valley Bank ran into trouble a few years ago. But obviously there are no guarantees that the government would indeed again insure beyond FDIC limits; it’s just my educated guess that they would, especially for a bank the size of Bank of America that’s structurally important to the U.S. banking system.

Certificates of Deposit (“CDs”)

Another bank product is Certificates of Deposit, or CDs. Unlike checking and savings accounts that allow you to more or less freely deposit and take out money as you please (subject to potential transaction number restrictions in savings accounts, like previously mentioned), CDs are fixed contracts where you put in a certain amount and aren’t supposed to take any of it out for a specific length of time.

CDs have stated maturities like six months, nine months, 12 months, 24 months, 36 months, etc. And they have fixed rates of interest that are guaranteed for the length of the contract. Meaning you decide the length of maturity you want, the rate will be known in advance, you put in however much you want (subject to any minimum the bank might impose, and again being cognizant of FDIC limits), and then you wait until the maturity of the CD and you can then take out your principal and all interest on it.

For example, assume you buy a 12-month CD that has an interest rate of 3.5%. And you decide to put in $100,000. In 12 months, your CD will mature. At the time, it will pay you $103,500, which is your original $100,000 of principal you put in, plus the 3.5%, or $3,500, or interest it accrued during that year.

Considering CD’s pay a guaranteed rate of interest, they normally charge a fee if you terminate the contract early. However, those early redemption fees are typically just foregoing some or all of the interest you thus far accrued. Rarely do the early redemption penalties dip into your principal such that you’d end up getting out less than you initially put in.

The potential benefit of a CD over a savings account is that the rate of interest is fixed for the length of the contract. So you don’t have to worry about your interest rate fluctuating and potentially decreasing over that time. However, that cuts both ways; you also are at risk of interest rates rising during your contract, yet your CD will still continue to pay only the lower contractual amount. But if you’re looking for a guaranteed known rate of interest for a certain length of time, CDs better fit that goal than savings accounts.

Considering CDs are designed for people to commit their money for longer than savings accounts, the interest rates on CDs are often higher than what you can get in savings accounts; but not always. So be sure to shop around.

But also, recall CDs normally have an early redemption penalty. So even if the interest rate on a CD is a bit higher than in a savings account, you might ultimately end up getting less interest in the CD if you have to bail on it early and the penalty wipes away some or all of your interest.

CDs are also subject to FDIC insurance limits. So again be aware of how much money you have deposited with any given bank, between all your checking, savings and CD accounts with them.

Another potential downside of CDs is that you must remember to actually terminate them, if that’s what you want to do. Otherwise, by default, most CDs will automatically roll into a new CD at whatever the market level of interest rates is at the time. And that might not be what you want to happen.

Money Market Mutual Funds

Now I’ll start talking about non-bank options for cash equivalents. The first of which are money market mutual funds (I’m going to call them MMMFs for short, to save myself some typing in the rest of this article!) As the name says, these are actually mutual funds, which means they’re securities and not bank products. And that means a few major distinctions, as I’ll discuss.

Because MMMFs are securities, you have to buy them in a brokerage account as opposed to a bank account. However, some banks offer MMMFs. I frankly don’t actually know the mechanics behind that. I’m guessing the bank is affiliated with a brokerage firm behind the scenes to hold the fund for you. Because, to my knowledge, a bank can’t directly hold a mutual fund on behalf of clients unless it’s also registered as a securities custodian.

Anyway, let’s assume you’re buying a MMMF not through a bank but through a normal brokerage account, like at Vanguard, Schwab or Fidelity. Because they’re mutual funds, you would technically have to place a buy (or sell) order to put money in (or take money out). However, some brokerage firms will automatically “sweep” any cash in your account to a money market fund. In that case, you wouldn’t have to consciously buy or sell the fund. Simply put, any time you put cash in your brokerage account, it would automatically go into the money market mutual fund. And anytime you want to take cash out of your brokerage account, it would automatically be taken out of that same money market mutual fund.

On the surface, money market mutual funds kind of look and act like savings accounts in some ways. Specifically, you put money in and you can reasonably expect that the value of your account will never be less than what you put in (though that’s not guaranteed; more on that in a bit). And then every day you have money in the fund, you will accrue a day’s worth of interest so that your total fund balance will grow. Technically, many (all?) MMMFs credit interest once a month. So only on those monthly crediting days will you see your position value actually increase. But in reality, you’re accruing interest every day. So if you were to completely sell out of the position intramonth, before receiving the month’s interest crediting, the fund company will pay you all of the intramonth accrued interest at the time.

MMMFs are funds that invest in short term liquid and safe debt instruments, like U.S. Treasuries (discussed more in the next section) and short-term debt obligations from highly rated corporations, where the debt obligation is often referred to as “commercial paper.” Because MMMFs invest in interest-paying things that are really short maturity and are generally from really safe and creditworthy borrowers, the funds typically don’t lose any principal value, yet consistently credit interest as described above.

Like savings accounts, the interest rate that MMMFs pay will fluctuate over time; it’s not guaranteed for a certain length of time like in the case of CDs.

One of the potential benefits of MMMFs is that they might pay interest rates that are higher than rates you can get on savings accounts. Also, the taxability of the interest on MMMFs might be more beneficial than on bank product interest. I’ll talk about that more toward the end of this article.

Another benefit is you don’t have to worry about FDIC limits with MMMFs. Because they’re securities and not bank products, the money you have in them is NOT owned by the fund or fund company. Unlike with banks, where the money you put in checking accounts, savings accounts and/or CDs IS owned by the bank.  The money and funds held in MMMFs is held separate from the fund company itself.

For example, if you own a MMMF managed by Vanguard, the money you have in the fund isn’t actually held or owned by Vanguard. Instead, it’s held in a third-party custodian, which I believe is typically State Street in the case of Vanguard’s funds. This means that even if Vanguard were to go bust and become insolvent, your MMMF positions wouldn’t be at risk of getting caught up within Vanguard and you not getting it back. Think about all the assets in all mutual funds, including MMMFs, being held in a big can separate and distinct from the fund manager, where you still fully own all your position in the fund and what’s inside that hypothetical can. Unlike a bank, where the bank is the can that holds - and owns - your money when you deposit it with them.

This means you don’t have to worry about keeping your MMMF size below the FDIC insurance limit of $250,000 per person per institution. However, for securities, there are separate federal insurance limits that come into play from the Securities Investor Protection Corporation, or SIPC. Specifically, that limit is $500,000 per account holder per institution.

But, in my opinion, you don’t need to be as concerned about managing to that $500,000 limits at securities firms as you do with the $250,000 limit at banks. That’s because, again, the securities companies don’t actually own your securities, whereas banks legally own your deposits with them. So you don’t really need to worry about the scenario of a securities firm becoming insolvent like you need to potentially worry about a bank becoming insolvent. The SIPC limit is really more so around the securities firm somehow losing your electronic securities. Which I frankly can’t really fathom how that can happen because there is so much industry-wide record keeping of all of this stuff.

But if a securities firm fails and your account or assets somehow go missing, SIPC insures up to $500,000. However, many firms, especially the larger more well-known ones, have additional insurance above and beyond the standard $500,000 SIPC limits. And again, the likelihood of your assets being at risk at a securities firm is much different - and lower, in my opinion - than your money at a bank being at risk.

The main downside with MMMFs is that they generally require one trading day to buy and sell. In other words, if you need cash out of your MMMF, you can’t just transfer it out that same day like you can when transferring money out of your checking account. You first have to put in a sell order to sell out of some of the fund. And then the cash will be available the next business day to then transfer out as needed.

But this is different in the case of places that automatically sweep cash to and from money market funds. In that case, you can practically think of the cash in the money market as cash sitting in a checking account in that it’s already always available for you to use and transfer out if/when needed.

The other potential downside (but not really, in my opinion) is that they aren’t technically guaranteed to be principal-protected. Recall I said earlier that the amount of money you can take out of a MMMF can reasonably be expected to never be less than what you put in? I say “reasonably expected,” because that isn’t formally guaranteed.

Given what MMMFs invest in (i.e. a basket of many different short-term and liquid debt instruments from creditworthy borrowers), there is virtually zero expectation that the funds will ever lose value. But it’s hypothetically possible that they can. And a few MMMFs have declined in value before.

One such example is the Reserve Primary Fund, whose net asset value dipped a few percent from what it was the day before due to its heavy concentration of commercial paper from Lehman Brothers. While Lehman Brothers was viewed as highly rated, it ended up going bankrupt very abruptly in September of 2008. Considering the large concentration to Lehman Brothers commercial paper which essentially became worthless overnight, the fund actually lost a few percent of principal.

However, realizing investors’ longstanding belief was that MMMFs aren’t expected to lose value, the government stepped in and backstopped the fund and made all investors whole (or at least I think everyone was ultimately made whole; I could be wrong though). Especially considering the extent of the troubles and uncertainty in the financial world at the time, the government wanted to bolster confidence in the system as much as possible.

So, while there is no formal guarantee that MMMFs won’t lose principal value, there is past precedent to reasonably believe it’s not likely to happen going forward. Or if it does, the government is likely to step in and backstop things, especially if it’s a large and well-known fund or fund manager, like a MMMF from Vanguard, Schwab or Fidelity.

Also, considering what happened with the Reserve Primary Fund, regulators have since beefed up standards on what MMMFs can invest in. For example, the Securities and Exchange Commission has since raised credit standards, reduced maturity requirements and improved fund liquidity rules for MMMFs.

Before wrapping up the MMMF discussion, I feel I should throw in a similar security that can be considered a cash equivalent. Certain Exchange Traded Funds, or ETFs, can look and act like MMMFs. Specifically, ETFs that invest only in short-term highly rated debt instruments (like MMMFs do) can be viewed as cash equivalents.

For example, there are some ETFs that invest only in super short-term US Treasury Bills (see the next section). As such, their price is reasonably expected to not decline, and they will accrue and eventually throw off some interest for every day you hold them.

Like MMMFs, ETFs need to be consciously bought and sold. And it takes one business day for the cash from sales to be available to use. The main difference between MMMFs and ETFs is that you can buy or sell ETFs any point during the day, whereas MMMFs only trade once a day, at the end of each day…even if you enter the order earlier in the day. But if you’re selling it because you need to pull the cash out to use, you still need to wait until the next business day in either case.

United States Treasury Bills

US Treasury Bills are short term bonds issued by the US Department of Treasury. Basically, it’s a loan to the Treasury where the Treasury agrees to pay back the amount borrowed, plus interest. And the loan, or Bill, is tradable in the market. In other words, the original “lender” who first buys the Bill is able to sell that IOU from the government to someone else, so that the other person will then eventually receive the repayment from the Treasury when the Bill matures.

Bills have maturities of up to 12 months. And they don’t pay any interim interest prior to maturity. The way they pay interest is that they ultimately pay out at maturity at $1,000 per Bill, but they’re bought for something less than $1,000 per Bill.

For example, if a 12-month Bill is currently paying or yielding 3.5% interest, the price to buy it today would be about $966. And then if you hold it until it matures, you’ll get paid out exactly $1,000.00 from the Department of Treasury. That difference of $1,000.00 - $966 = $34 equates to 3.5% on your original purchase of $966.

Because Treasury Bills are securities, you again have to buy them in a brokerage account; they can’t be bought within a bank account. Or alternatively, you can set up an account directly with the US Treasury at www.TreasuryDirect.gov and buy and sell Bills there. However, I find it easier to just buy and sell them in a regular brokerage account, assuming you already have one. Otherwise, opening a Treasury Direct account is one more account to have to set up a login for, keep track of, get tax reporting documents from, manage, etc.

Like CDs, the interest rate on Treasury Bills is known and fixed, assuming you hold it until it matures, such as in the example I gave above, where you will ultimately realize 3.5% interest. So if you’re looking for a fixed rate of interest for up to a year, Treasury Bills could be an option. Like with CDs, having a fixed rate of interest for a certain length of time could end up being a good thing or a bad thing; it all depends how interest rates move during that time. If interest rates go down, you’re still getting whatever original yield that Bill has, which is good. But vice versa if interest rates go up, where current rates would be higher but you’d still be getting that same original yield of the Bill.

A benefit of Treasury Bills is that you can sell them prior to maturity if you want or need to and there is no formal early redemption to speak of. However, the price at which you sell them isn’t guaranteed. You can potentially have a little principal loss on Bills, particularly if you sell it soon after you bought it AND the market level of interest rates has since increased. But if you hold a Bill more than just a few weeks, the chance of losing any principal from selling it before maturity is rather low.

And even if you don’t necessarily lose principal, if you sell the Bill prior to maturity you might not end up realizing the interest rate you would have if you held it to maturity. Recall that you know with certainty what interest you’re going to end up getting if you hold a Bill to maturity. But if you sell it early, you might end up yielding a bit more or less than what you originally thought. The difference won’t be drastic, but it could be a difference nonetheless.

Another benefit of Treasury Bills is that the interest on them is tax-free at the state level. This could potentially make a meaningful difference, particularly if you have a high state income tax rate and/or have a lot of interest.

While I only mentioned Treasury Bills here, you can also potentially consider longer maturity US Treasury bonds as cash equivalents. Technically, a Treasury “Bill” is something that matures in a year or less. A Treasury “Note” is a Treasury bond whose original maturity was between one year and 10 years. And then a Treasury bond whose original maturity was more than 10 years is formally called a Treasury “Bond.” But generically speaking, most people just refer to ALL forms of tradable US Treasury debts as Treasury “bonds.”

Anyway, if you buy a Treasury Note, for example, it’s maturity will be more than a year, and it will pay an ongoing interest payment – known as a “coupon” – to you every six months. And then it will pay the Notes’s face value at maturity. Such a $1,000, like with a Bill.

However, depending on the maturity of the Note or Bond, there could potentially be much larger price swings compared to a Bill. Which means if you were to sell the Note or Bond before it’s maturity, there could be a significant principal loss.

I won’t get too into the math mechanics of why longer maturity bonds have more price change potential than Bills. But just know that the longer the maturity of the bond, the more its price will change as interest rates change.

For example, assume you buy a new 30-year Treasury Bond today and plan to hold it for all 30 years to receive its interest payments every six months, and then get the face value paid out to you at the end. But then a year in, life changes and you need to sell the Bond for whatever reason. If long-term interest rates increase by one percentage point between now and a year from now, the price of that 30-year Bond will decline somewhere between 15-20%. Which means when you sell it in a year, you will have lost over 15% of your principal.

And vice versa; if long-term interest rates decline one percentage point over the next year and you then sell the Bond, you will make over 15% from selling the Bond.

With this in mind, I don’t consider longer-term Treasuries as cash equivalents because there is too much risk of principal loss if you need to sell them before maturity. I definitely consider Treasury Bills cash equivalents because the principal loss risk is negligible.

Multi-Year Guaranteed Annuities

The final cash equivalent I want to bring up are Multi-Year Guaranteed Annuities, or MYGAs. Though I’m torn on considering them cash equivalents because of their significant restrictions on liquidity.

I won’t get too into the details of what it means for a MYGA to formally be an annuity, and what all is involved in that. But in a nutshell, a MYGA is a private contract between you and an insurance company where they agree to pay you a fixed rate of interest for a fixed length of years.

For example, assume you buy a three-year MYGA from an insurance company and they contractually agree to pay you 4.0% interest per year on your money. What happens is you put in however much you want, subject to whatever minimum contract size the insurer might require, which is generally like $5,000 or $10,000. Or higher, such as $100,000, if you want to get a better rate. Let’s assume you put in $100,000.

In this example, at the end of three years, the insurance company will pay you a total of $112,486. Which is made up of your original $100,000, plus three years of interest compounded at 4.0% per year on that $100,000. That’s it at a super high level.

However, there are strict early surrender provisions. Generally speaking, most insurers will let you withdraw up to 10% each year with no penalty. But if you withdraw more than that, there will be an early surrender charge. And those charges up often start at high single-digit percent per year, where the penalty percentage typically decreases a bit each year.

Given their fairly high early surrender penalties and minimum lengths of maturities that are generally at least one year (if not two years or more), I have some hesitation with considering MYGAs cash equivalents. But considering their principal protection and guaranteed fixed rates of interest, I feel I need to at least mention them in the discussion of cash equivalents.

The main benefit of MYGAs is that they often pay higher rates of interest than other fixed maturity and fixed rate alternatives like bank CDs.

However, those higher rates come at the expense of more costly restrictions on early redemptions/surrenders, which is an obvious downside if you need to get out of the MYGA early.

Another potential drawback of MYGAs is like that of CDs in that when the contract matures, you typically have to proactively opt to close it and take the money out (if that’s what you want to do), otherwise it will automatically roll into a new MYGA at whatever prevailing market rates are at the time. And there will be a new set of early surrender penalties that will apply.

And this next point isn’t necessarily a pro or con between MYGAs and bank products or securities, but it’s nonetheless a difference to be aware of. Whereas bank deposits are insured by federal FDIC insurance and securities are insured by federal SIPC insurance, MYGAs are insured at the state-by-state level via each state’s insurance guaranty fund.

In general, I’m of the opinion that federal insurance backstops are generally going to be stronger than state-level backstops if/when times get really nasty and banks, brokerage and/or insurance companies start going bust. But that’s just a hunch.

TAXATION CONSIDERATIONS

I want to briefly recap how each of the above cash and cash equivalent options is taxed, both at the federal and state level. This info is important to know, as it might impact your decision of which form of cash or cash equivalent you feel is best for you.

Again, I’m assuming all the above options are held in the normal “non-qualified” account world, and not in any sort of “qualified” account like an IRA or Roth IRA.

Physical bills – There is no tax impact federally or at the state level. Because the cash you have in your wallet or in your house isn’t earning any interest, there is simply no taxable income generated from it.

Checking accounts – Any interest you receive from a checking account is taxable to you in the year you receive it. And the interest is fully taxable as ordinary income both federally and at the state level (if you live in a state with income tax).

Savings accounts – Same tax treatment as a checking accounts.

CDs – Similar to checking and savings accounts, but with a potential little twist. If the CD has an original maturity of one year or less, interest generally isn’t reported as taxable until the maturity of the CD. For example, if you buy a one-year CD in June of 2026, you will have accrued six months of interest for the year as of December 31, 2026. However, that interest won’t be reported as taxable to you until 2027, where all one year of interest will then be reflected as taxable to you. And it will be fully taxable as ordinary income both federally and at the state level (if you life in a state with income tax). However, if the CD’s original maturity is more than a year, then the bank will generally report each year’s accrued interest as taxable to you in that year, even though the CD may not have matured yet and you didn’t actually technically get paid out any of the interest in that year.

Money Market Mutual Funds (and certain ETFs) – This is where it gets interesting. Interest received from securities issued by the US government is fully taxable as ordinary income at the federal level. However, it’s not taxable at the state level, even in states with an income tax. And this state tax treatment applies on a passthrough basis to funds like MMMFs and ETFs that hold US Treasury securities and therefore pass through interest from said securities as dividends. But certain states are jerky about this. For all states except CA, CT and NY, any portion of dividends from MMMFs or ETFs that is attributable to US Treasury interest is tax-free at the state level. But CA, CT and NY have hurdles the funds need to meet in order for the passed through US Treasury interest to be state income tax-free. For example, in CA, you can’t exclude any portion of a MMMF or ETF’s dividend from income unless at least 50% of the fund’s interest is from US Treasury security interest.

US Treasury Bills – As I touched on above, any interest received from US Treasury securities is completely income tax-free in all states. Therefore, any interest received from US Treasury Bills is free from state income tax. But like I mentioned above, if you invest in a MMMF or ETF that holds Treasuries, the dividends from those funds may or may not be excluded from state income tax, depending what state you live in and how much of the fund’s dividends are from US Treasuries.

MYGAs – All interest from MYGAs is fully taxable as ordinary income federally and at the state level (in states that have income tax). However, the recognition of taxation on annuity interest is deferred until you eventually surrender and cash out the annuity. In the example I used above of buying a three-year MYGA, the MYGA accrued interest each year at 4.0%. However, none of that interest was taxable along the way. You wouldn’t have to pay tax on the interest until you eventually close and cash out the annuity. And if you roll it to another annuity, that would continue to defer the recognition of taxation on the interest until you eventually close and cash out the new annuity.

PULLING IT ALL TOGETHER

In closing, what’s the best form(s) of cash or cash equivalents for you to hold??? It depends. What’s your willingness and ability to have rates of interest that fluctuate over time vs having rates of interest that are fixed for a certain length of time? Or what’s your willingness and ability to accept early redemption or surrender penalties to hopefully otherwise get some higher interest? Or what’s your personal preference for keeping money within banks vs within brokerage companies or insurance companies? Or what’s your federal and/or state income tax situation and sensitivity, and how does that play into choosing which option has the most tax-efficient interest rate for you?

All said and done, where you choose to hold your cash and cash equivalents isn’t likely to make or break your long-term financial plans. There are obviously big things to pay attention to, like don’t keep a million dollars in cash in a single small Podunk bank. Because if that bank fails, you might lose all of your money in excess of your applicable FDIC insurance limit. And don’t put all your money in MYGAs if you know you’re going to need to pull it all out within a few months, because the early surrender penalties will really add up. And don’t keep a lot more cash in checking accounts than you need to, because the low interest rates could potentially lead to a meaningful drag on long-term growth over time.

But other than these few big things to keep in mind, it can often be an exercise in splitting hairs in deciding which form of cash or cash equivalent is going to be the best for you. Know your options, be aware of potential pros and cons, and make the decision that you feel most comfortable with for whatever your reasons are. Done.

Disclaimer:

None of the information provided herein is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied.  Tenon Financial LLC does not promise or guarantee any income or particular result from your use of the information contained herein. Under no circumstances will Tenon Financial LLC be liable for any loss or damage caused by your reliance on the information contained herein. It is your responsibility to evaluate any information, opinion, or other content contained.