Here I count everything from college tuition due next fall to the down payment on the house you hope to buy the year after next. You can’t risk losing a penny of it, so you can’t afford to play around. On the other hand, neither should these funds nap in a low-interest savings account. By choosing a guaranteed investment that pays a higher interest rate, you’ll pile up savings faster.
Most of you will agree with me about keeping six-month money safe. But five years sounds a lot further away. Why not invest in stocks for growth? Here’s my argument: Stock prices rise and fall. For money you’ll absolutely need, it’s the "fall" you have to worry about. If you have the bad luck to invest just before stocks go into a decline, you’ll lose some of your principal, which could be disastrous if that money is needed to pay a specific bill. Since 1929, it has taken inves¬tors an average of nearly four years to get even again after a major stock market drop, assuming that dividends were reinvested.
If you’re more adventurous, you might decide to keep only two-year money totally safe. Since World War II, the average stock market dip and recovery took just over two years. Still, the second longest dip and recovery on record started in August 2000 and lasted until October 2006—more than six years. And then the market fell again, with years of recovery still ahead! How much risk are you willing to take with money you must have within a shorter period of time?
Places to Keep Medium-term Money:
Certificates of deposit. With a CD, you put your money in a bank or credit union for a fixed term. You normally earn a higher interest rate than you would in a bank money market deposit account.
Some people hate CDs because they feel that their money is locked away. But it’s not. You can break into a certificate anytime you want before maturity. The worst that can happen is that you’ll pay an interest penalty. Big deal. That’s nothing compared with the interest you lose by keeping too much money in a low-interest savings account. If you balance risk and reward, CDs are a shoo-in. Most savers will not face an emergency need for cash. You’ll hold your CD to maturity and earn more interest along the way. Note that CDs at online banks usually pay more than those at traditional banks.
Institutions may offer standard terms for CDs, such as 6, 12, or 30 months. Some let you pick whatever term you like. Normally, the longer the term, the more interest you earn. For how to get higher interest through laddering CDs.
U.S. Treasury Securities. A Treasury security is the fruit of federal deficit spending. When the government spends more money than it collects in taxes, it has to borrow to make up the difference—and it borrows from you, by selling you Treasuries. You are actually lending money to Uncle Sam for a fixed period, earning interest all the while.
To buy Treasuries, go online to TreasuryDirect (www.treasurydirect.gov) and set up an account. You can do it in five minutes flat. If you aren’t online, write to the nearest Federal Reserve Bank for the forms you need. The job is not exactly a brain buster and there are no charges to pay when you buy direct from the Fed. Still, I can hear some of you groaning. If this sounds like too much work, a bank or a stockbroker will buy Treasuries for you for a fee. Or you can buy a TIPS mutual fund.
What’s your reward for becoming a Treasury investor? In most states, an instant break on your income taxes. The interest you earn on U.S. Treasury securities, while taxed at the federal level, cannot be taxed by states and cities. So you might earn a higher after-tax return than you’d get from the average certificate of deposit.
The minimum investment for Treasuries is $100. The yield is set through public auction by the big institutions that put in bids. When you buy directly from the Federal Reserve, you piggyback on what the institutions pay. You’ll find the auction dates at TreasuryDirect.
Which Treasuries to buy depends on when you’ll want the money:
Treasury bills mature in four weeks, three months, or six months. You send the Fed a certified check for the bill’s face amount or authorize a direct payment by your bank. Immediately after the auction you get a discount payment back, representing the difference between the face value of the bill and the lower auction price. At maturity, you’re paid the face value. Your profit is the difference between the two. For example, say you send $1,000 for a six-month bill that sells for $950. The Treasury sends you $50 back. At maturity, your T-bill pays $1,000, for a $50 profit.
There are two ways of measuring your return on investment. The newspaper stories generally highlight the discount rate, which compares your profit ($50) with the bill’s face value ($1,000). By this measure, you’ve apparently earned 5 percent.
But that understates what you’ve really earned. After all, you didn’t put up the full $1,000. In this example, you invested only $950. A $50 return on $950 comes to about 5.3 percent. That’s called the coupon-equivalent yield and is the true measure of your return. Use it to compare the profit in Treasury bills with what you might get from alternative investments, such as bonds and CDs. You’ll find the coupon-equivalent yields on the Web site TreasuryDirect.
T-bills let you play income tax games. If you buy a security today that matures in the next calendar year, your interest income falls into that year, so you defer the tax you owe. Note that your taxable profit is not the discount check that the Treasury sends you right away. It’s the profit you make when the bill matures.
Treasury notes mature in two, three, four, five, seven, or ten years. Different maturities are auctioned at different times (you’ll find the dates at Treasury-Direct). Just authorize a withdrawal from your bank account for the face amount of the notes you want, or mail a check. Immediately after the auction, you will usually get a few dollars back because the notes sold for a hair less than their face value. Only one yield is reported (there’s no coupon-equivalent yield to worry about, as with Treasury bills). Interest is paid on your full investment twice a year.
When choosing Treasury notes, pick a maturity that coincides with the date you’ll want to use the money.
Treasury Inflation-Protected Securities (TIPS) are issued for terms of 5, 10, and 20 years. They protect both your principal and interest from inflation. Your principal rises by the percentage change in the consumer price index (the increase is compounded daily and added to the value of your bond every six months). The interest rate is fixed, but it’s paid on a rising amount of principal, which means that your income, in dollars, increases too. If inflation rises by 1 percent, the value of your TIPS will also rise by 1 percent.
Your principal’s increase in value is taxable in the current year, even though you don’t get the money until the bond matures or until you sell before maturity. For this reason, investors prefer to hold individual TIPS in tax-deferred retire¬ment accounts. Most TIPS mutual funds work differently. They pay out the gain in your principal in monthly or quarterly installments, so you have cash in hand when your taxes come due.
Initially, TIPS pay a lower interest rate than you could earn on fixed-rate treasuries, but they’ll pay more if inflation rises faster than people generally expect. For help in choosing between TIPS and fixed-rate Treasuries.
Shorter-term zero-coupon Treasuries can be good ways to save over four years. A zero is a Treasury note bought for less than its face value. It pays no current interest (also called the “coupon”). Instead you buy the note for less than its face value. Every year the interest builds up within the bond until it reaches face value at maturity. For example, you might pay $865 (before sales commissions) for a zero that will be worth $1,000 in five years. That’s an annual compound yield of 4.8 percent.
Zeros are sold by stockbrokers and banks, not through TreasuryDirect. Just be sure that you can hold the note until its maturity date. You may lose money if you have to sell a zero before maturity.
What’s nice about zeros is that they reinvest your interest at the same rate that you’re earning on the bond itself. With the zero just discussed, for example, you earn 4.8 percent on every interest payment. With other bonds, you’re paid in cash and have to reinvest the money yourself. Small payments (if not spent) will probably land in a bank account or money market fund, where they’ll generally earn much less than you’re earning on the bond itself.
What’s bad about zeros is that you’re taxed every year on the interest that builds up, even though you don’t physically receive the money. If you’re younger and will want the cash at maturity, you’ll have to grin and bear it. If you’re older and can wait for the cash until after age 59½, buy your zeros in a tax-deferred retirement account.
A four-year zero-coupon Treasury is a reasonable bet for your teenager’s education fund. Buy one when the child is 14 years old, to cash in when he or she reaches 18. Your money is safe, and the earnings should compound at a reason-able rate of interest. (For younger children, don’t buy zeros, buy stock-owning mutual funds.)
Long-term zeros are another story. Like other Treasury bonds, they’re generally wrong for short-term savers. When interest rates rise, zeros lose value faster than other bonds do, which can hurt you if you have to sell before maturity.
Treasury bonds have the longest maturities, generally up to 30 years. They’re auctioned in the same way as Treasury notes, with interest payable twice a year. I mention them here only to be orderly. Long-term Treasuries aren’t the right place for savings you might have to tap. If you sell them before maturity, you’ll be exposed to the hard, cold winds of the open market, where your bond might bring less than you originally paid. The newer inflation-indexed Treasuries don’t vary in price as much as conventional Treasuries, but they pay a smaller current income.
From MAKING THE MOST OF YOUR MONEY NOW by Jane Bryant Quinn. Copyright © 1991, 1997, 2009 by Berrybrook Publishing, Inc. Reprinted by permission of Simon & Schuster, Inc.
