Chapter 5 – Savings and Cash (Finance 123)
I. Cash Management – Short Term and Long Term
Short Term – Checking Account – FDIC insured
Money Market fund – not insured.
Credit Card – FICA or credit score
Debit card – comes out of checking account, get “overdraft protection”.
Long Term – Certificates of Deposit, US Savings Bonds, Govt Bonds (taxable and tax free, discussed later). These “cash equivalents” become part of an overall investment strategy that includes stocks, mutual funds, rental property, etc.
II. Debit Card vs. Credit Card
Debit card is just another way to write a check. Overdraft charges apply. Get overdraft protection.
Your ability to get a credit card will depend upon your FICA score (credit score). Finance charges and penalties will vary dramatically. Know the details.
III. Depositing Your Savings
Bank – FDIC insured - $100,000 per “entity” per bank.
Similar insurance for Savings and loans (FSLIC) and credit unions.
FDIC formed during
Similarly, we will learn about the SIPC (Securities Investors Protection Corporation) when we talk about investing in stocks.
Why would a person limit a Certificate of Deposit purchase at a particular bank to less than $100,000 (say $95,000)? To keep the value of the principal AND accrued interest at less than $100,000.
IV. Balancing Your Checkbook
Easiest way to think about it: When you get your bank statement, there are things you know that your bank doesn’t know; and, there are things your bank knows that you don’t know. Your job is to “inform the other”. Post bank transactions to your checkbook, and, post checkbook transactions to your bank statement.
Example:
Checkbook balance $356
Bank statement balance $472
Service charges $15
Interest $4
Checks outstanding $187
Deposits in transit $60
Here’s what “balancing your checkbook” would look like:
Checkbook balance $356
Less Service charge (15)
Add interest $4
True balance: $345
Bank statement balance $472
Checks outstanding (187)
Deposits in transit 60
True balance: $345
V. After Tax Rate of Return – Comparing taxable and tax free bonds at different marginal tax rates
Bonds issued by states and cities (municipalities) are free from federal income tax. This provides tax-free income for investors. When should investors buy the tax-free bonds (which usually pay less interest), and, when should they buy the taxable bonds?
Bottom line: Investors in high marginal tax rates should buy the tax free bonds. Investors in low marginal tax rates should buy the taxable bonds. Here’s the math:
Taxable bond yielding 6%
Tax Free bond yielding 4%
To get the “taxable equivalent yield” of the “tax free bond”, here’s the formula:
Tax Free Interest Rate / ( 1 – marginal tax rate)
Assume an investor is in the 10% tax bracket:
The “taxable equivalent yield” of the tax free bond is:
4% / ( 1 - .1) = 4.44% (this is less than the taxable bond of 6%, buy the taxable bond.)
But, assume an investor is in the 38% tax bracket:
The “taxable equivalent yield” of the tax free bond is:
4% / ( 1 - .38) = 6.45% (this is higher than the taxable bond of 6%, buy the tax free bond).
Notice how the decision was directly determined by the taxpayer’s marginal tax rate. Why? The taxable bond is better for the investor in the low tax rate, because he/she doesn’t pay that much in taxes anyway. But, for the investor in the high tax rate, he/she pays so much of a percent in taxes, the tax free bond is better (it’s more advantageous to avoid taxes when you’re paying a really high tax rate).