SHORT-TERM SAVINGS CENTER

Savings Options

Short-term Savings

Where NOT To Stash Your Cash

Retirement accounts: Tempted to take out loans from your 401(k) or withdraw contributions (the money you've deposited) from your Roth IRA penalty-free? Unless you are willing to develop a taste for cat food, don't shortchange your future. If you must, though, take the loan, because you can't replace borrowed Roth contributions. Don't even consider taking money out of a regular IRA unless you like donating around half of it to Uncle Sam in the form of taxes and penalties.

Collectibles such as coins and antiques: If you need to raise funds from collectibles in a hurry, the sharks smell blood in the water, and you are less likely to get a good price for Great Aunt Betsy's Colonial-era sewing kit.

Long-term bonds: When you buy a bond, you are guaranteed a set amount of interest plus the return of your principal on the maturity date. Before that, all bets are off. If you want your principal back before the maturity date, you have to sell the bond for the going price, which could be less than the face value. The longer the term, the more sensitive bond prices are to interest rate changes.

Your family: Yeah, you've got a lot invested in those kids, and you might get a nice price for them on eBay, if they are polite and don't eat much. But we can't recommend liquidating this asset, tempting as it may be at times.

The Big No-No: The Stock Market
Ask yourself: Why do stocks pay more than fixed-income investments over the long run? Because sometimes (the year 2000 comes to mind) stocks pay LESS over the short run. An average annual return of around 4% is a reasonable average for fixed-income investments. The market does better than that most of the time, but not always: From 1926 to 2000, the market returned less than 4% in one out of every three years, and most of those sub-4% returns were negative.

If you are saving for a down payment on a home, car, college, or new chin in the next few years, there is a significant possibility that a stock market investment will be in the red when the time comes to buy.

By Robert Brokamp

There are so many places to stash your short-term savings. Here we present the résumés of the major aspirants:

Checking Accounts

Checking accounts are meant for transactions, not savings. That's why many don't pay much, if any, interest. However, some banks do combine the conveniences of checking with the return of a money market account. Also, as "asset management" accounts at brokerages become more feature-rich -- offering unlimited check writing, ATM access, and money market rates -- more folks are shunning the banks in favor of brokers.

Pros

  • Your money is only a check or ATM machine away.
  • A bank branch is usually not far, often in your grocery store, if you're so old-fashioned as to want to deal with a human being.
  • As with all bank deposits, checking accounts are FDIC insured.

Cons

  • Depending on the bank, you may not earn much, if anything, on the money in your account.
  • Many checking accounts require a minimum balance, and/or charge fees that are a pox upon your pecuniary patience.

Savings Accounts

In the old days, savings accounts -- or passbook accounts, as they're sometimes known -- were the most popular rest area for short-term savings. Fortunately, folks are getting smarter and parking their pelf in higher-yielding investments. The 1-2% you earn in a savings account isn't enough to even keep up with inflation.

Pros

  • The money in a savings account is FDIC insured.
  • Account minimums are often low.

Cons

  • The return on savings accounts are so low, some mattresses pay more in interest. (Not really, but what happens on mattresses is more interesting.)

Money Market Deposit Accounts

Money market deposit accounts are offered by banks, usually require a minimum balance, and permit a limited number of transactions (six transfers, three of which can be checks written on the account).

Pros

  • Money market deposit accounts are very liquid. Most allow for easy access through checks, transfers, and even ATMs.
  • Since they are offered by banks, money market accounts are FDIC insured.

Cons

  • Unfortunately, you may pay for the liquidity by receiving less in return than from certificates of deposit.
  • If your account falls below the minimum required balance, or you exceed the limited number of transactions, you might pay a penalty.

Money Market Funds

Money market funds are offered by brokerages and mutual fund families. These funds invest in highly liquid, safe securities such as certificates of deposit, government securities, and commercial paper (i.e., short-term obligations issued by corporations).

Pros

  • With a money market fund, you can have the money in your hot little hands very quickly. Often, you can write checks or use an ATM card.
  • The returns on money market funds are typically higher than the return on money market accounts.
  • Issuers go to great lengths to keep the NAV (the price of each share of the fund) at $1, so your principal is relatively safe.

Cons

  • Money market funds are not FDIC insured.
  • There is no guarantee that the NAV will remain at $1.

Certificates of Deposit (CDs)

CDs are debt instruments with a specific maturity, which can be anywhere from three months to 60 months (i.e., five years). Most CDs are issued by banks, but they can be bought through brokerages.

Pros

  • CDs are very safe since most are offered by banks and are thus FDIC insured.
  • Depending on the length to maturity, CDs may pay more than money markets.

Cons

  • Your money is off-limits until the CD matures. If you must, you can redeem the CD early, but you'll pay a penalty.

U.S. government bills or notes

"Treasuries" are backed by the full faith and credit of the U.S. government. Treasury bills mature in less than a year; Treasury notes mature between two and 10 years.

Pros

  • Treasuries are considered the safest investments in the world.
  • They can be bought directly, commission-free, at TreasuryDirect.
  • They are exempt from state and local taxes.

Cons

  • If you shop around, you might get a better return from money markets, CDs, and corporate bonds.
  • If you need your money before the security matures, you may not get back all of your original investment.

I Bonds

No, they have nothing to do with the Internet. I Bonds are inflation-indexed savings bonds issued by the U.S. government. The amount an I Bond pays is adjusted semiannually so as to keep up with inflation and protect the purchasing power of your money.

Pros

  • I Bonds are backed by the full faith and credit of the U.S. government.
  • The "I" in I Bond protects your investment against inflation risk.
  • They are sold in manageable denominations, ranging from $50 to $10,000.
  • They can be bought from most financial institutions, including TreasuryDirect.
  • The earnings are exempt from state and local taxes, and can be tax-free if used for post-secondary education expenses.
  • Taxes on earnings can be deferred for up to 30 years.
  • The yield ain't too shabby. I Bonds issued between May and October 2001 will pay 5.92% for six months (at which point the earnings rate will be adjusted to account for inflation).

Cons

  • You must hold an I Bond for at least twelve months, and you will pay a penalty of three months' earnings if you redeem the bond before owning it for five years.

Municipal bonds

Municipal bonds (or "munis," as the big talkers refer to them) are issued by state and local governments in order to build schools, highways, and other projects for the public good. Municipal bonds are most attractive to high-income investors looking for tax-friendly income.

Pros

  • Munis are just a step down from U.S. securities in terms of safety.
  • Income is exempt from federal taxes, and might be exempt from state and local taxes if you live in the municipality that issued the bond (check on the tax implications beforehand).

Cons

  • Interest from munis is relatively low. Unless you're in a high tax bracket, you'll get a better return from other investments. (See our Bond FAQ to learn how to compare tax-free bonds and corporate bonds.)
  • You may have to pay a commission to buy municipal bonds.
  • If you need your money before the bond matures, you may not get back all of your original investment.

Corporate bonds

Corporate bonds represent debt issued by companies, from the blue chips to the "cow chips," if you know what we mean. The more creditworthy the company, the less it'll pay in interest. Moody's and Standard & Poor's rate companies as to their ability to meet their debt obligations. Only short-term bonds are appropriate for short-term savings.

Pros

  • Corporate bonds usually pay more than government securities, money markets, and CDs.

Cons

  • The company that issued the bond could suspend interest payments, or even go belly-up.
  • You may have to pay a commission to buy bonds.
  • If you need your money before the bond matures, you may not get back all of your original investment.

Bond funds

Bond funds are mutual funds that pool the money of investors to buy bonds of all stripes.

Pros

  • They are an efficient way to buy bonds in small increments and get the diversification that minimizes the risk that you picked a bond from a dead-beat company.

Cons

  • The NAV (i.e., the share price) of a bond mutual fund fluctuates, due to interest rate movements and the bonds bought and sold inside the fund. Therefore, you're not sure exactly how much of your original investment will be around when it's time to take your dough. Likewise, the yield on a mutual fund fluctuates.
  • You will pay an ongoing expense to own the fund, called the "expense ratio," and you may have to pay a commission, called a "load."
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