Bank Certificates and Tax-Exempt Money-Market Funds

Bank Certificates and Tax-Exempt Money-Market Funds

Bank Certificates

Banks also offer certificates of deposit with a variety of periods to maturity. Yield on these instruments are typically higher than those on either money-market deposit accounts or money funds. These certificates are government insured up to $100,000 per buyer (double with your spouse). Thus, the certificates are even safer than the money funds and are an excellent medium for investors who can tie up their liquid funds for at least six months.

The certificates do have a number of disadvantages, however. First, you need to have a substantial nest egg – usually $10,000 – before you can buy. Second, you can't write checks against the certificates as you can with shares in the money funds. Most important, as in other aspects  of life there is a substantial penalty for premature withdrawal. If you redeem your certificate prior to maturity, federal regulations stipulate a minimum penalty of the loss of one month's interest. Some banks impose even greater penalties. Fourth, the yield on bank certificates is subject to state and local taxes (Treasury bills, also obtainable for $10,000, are exempt from these).

The two steps in any action – finding your risk level and identifying your tax bracket and income needs – seem obvious. But it is incredible how many people go astray by mismatching the types of securities they buy with their risk tolerance and their income and tax needs. The confusion of priorites so often displayed by investors is not unlike that exhibited by young people who are often torn by a confusion of priorities. You can't seek safety of principal and then take a plunge with investment into the riskiest of common stocks. You can't shelter your income from high marginal tax rates and then lock in returns of 10 percent from taxable corporate bonds or certificates, no matter how attractive these may be. Yet, the annals of investment counselors are replete with stories of investors whose security holdings are inconsistent with their investment goals.

Financial Jungle. Photo by Elena.

Tax-Exempt Money-Market Funds

This instrument may be useful for some investors, particularly those who pay taxes at the top marginal rate and who live in states with high income-tax rates. A disadvantage of all the vehicles is that the interest is fully taxable. Investors in very high brackets will find that, after taxes even the highest of the yields offered will not compensate for inflation. This situation led to the establishment of the first tax-exempt money-market fund, the Vanguard Municipal Bond Fund short-term portfolio.

Vanguard invests in a portfolio of short-term, high-quality, tax-exempt issues. It thus produces daily tax-exempt income. Like the regular money-market funds, it provides instant liquidity and free checking for large bills, with rather high minimum investment. There are now several tax-exempt money funds. The yields on tax-exempt funds are considerably lower than those on taxable funds. Nevertheless, individuals in the highest tax brackets will find the earnings from this investment more attractive than the after-tax yield of the regular money funds.

If you live in a state which has high income-tax rates, you may want to consider a fund that only holds securities issued by entities within your home state. Tax-exempt bonds issued, for example, by New York municipalities are taxable in other states. Thus, the only way for, say, a Californian to avoid both federal and state taxes is to buy a fund that holds only California securities. Fortunatley, there are now tax-exempt money funds (as well as bond funds) available that invest in the securities of a single state. There are not available for all states. You should call one of the mutual-fund complexes such as Fidelity or Vanguard to check on the availability of a fund that invests in securities of the state in which you pay taxes.