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Brokerage accounts and IRAs are not individual investments. They're simply accounts that are there to house the investments that you choose to buy within them. If you deposit cash into your brokerage account or IRA, then it will be uninvested until you decide to buy a stock, bond, mutual fund, CD, or other investment vehicle with it.
Because your money should not sit in cash without any growth, most firms and investment banks create something called a "sweep" account. A sweep account is a standard vehicle within a brokerage account or IRA that all incoming cash and dividends are "swept" into until the investor invests it. Sweep accounts offer a low-risk, low-return on cash and dividends that are uninvested. Often, this sweep account is a money market account. Money market accounts are the perfect choice for sweep accounts because they offer a small return while an investor decides what to do with his or her cash. They invest in low-risk securities like Treasuries so the investor does not need to be overly concerned about losing their liquidity. Money market sweep accounts are also FDIC insured.
Even the simplest form of investment carries some confusing aspects, and money markets are no exception. When talking about money markets, investors could be speaking about two completely different things:
Money market funds, on the other hand, are a completely different animal.
What is a money market fund?
A money market fund is like a mutual fund. It's an investment that you can buy shares of and hold in your brokerage or retirement account. Shares are generally purchased at NAV. NAV is short for net asset value, which is the value of the fund assets minus any liabilities. NAV is generally kept at $1.00. The fund is comprised of many underlying investments, including CDs, bonds, and other low-risk positions. These investments create growth within the fund that is paid out as a dividend to investors.
Money market funds offer no guaranteed growth and are not a fixed investment like CDs. Their redemption value can vary but does not generally dip below NAV.
Chances are good that you've never heard your investment broker suggest a money market account or money market fund for a long-term investment of a large amount of cash. Why? While money market accounts and money market funds are both low-risk investments or accounts, they're also low-return, with rates hovering anywhere from less than 1% to about 2% at any given time. Returns this low do not offer enough growth opportunity to make them a worthwhile investment over the long term.
Good Uses for Money Markets
The difference between money market deposit accounts and money market funds are many, but one of the most important differences to understand is the protection you have against the bankruptcy of your bank or investment firm, depending on the type of money market you have.
Money market accounts at certain banks are Federal Deposit Insurance Corporation (FDIC) insured up to $100,000 (temporary insurance measures have increased this to $250,000 until 2013). That means that if the bank with which you have a money market deposit account goes bankrupt, the federal government will reimburse you.
The Securities Investor Protection Corporation (SIPC) is not a federal program, but is a member-funded program that protects investors up to $500,000 if their brokerage firm goes bankrupt and loses their assets. It's important to understand that a brokerage firm doesn't always actually hold your physical assets but just reports on them, so often this coverage is unneeded. For instance, if you have a mutual or money market fund, you can probably still contact the fund family and link the information to a new brokerage account--which means you haven't actually lost anything. A money market fund would be covered by SIPC if your brokerage firm actually did somehow lose the fund value through bankruptcy or insolvency.
A tax-free or tax-exempt investment vehicle often perks up the ears of investors, but believe it or not, it's easy to make bad decisions when investing in tax-exempt vehicles, one of which involves purchasing them in your IRA.
Tax-exempt money market funds are generally comprised of government securities from local municipalities. The growth of these funds is generally exempt from federal taxation and may be exempt from state taxation as well. Because they have the added benefit of tax-exempt growth, they offer a low interest rate (or yield). But because IRAs already offer tax-deferred growth by their very nature, investors with tax-exempt money market funds in them just get a low return without any additional tax-saving benefits.
A better option for IRA investors is to spend some time and compare money market funds. Choose a fund with a high yield and buy it with the proceeds within your IRA. As long as the growth of the fund is within the IRA, you won't pay taxes on it. If you have a traditional IRA, you'll pay taxes as you begin to take distributions from your IRA, but you'll pay taxes based on your lower-income, senior tax bracket.
There are two ways to invest in money markets. You can buy a money market fund or open a money market deposit account.
Money Market Fund
A money market fund is an investment vehicle like a mutual fund, and you may need a financial advisor to help you invest in one. A money market fund offers a fixed return, called a dividend. The dividends are taxable unless you buy a tax-free or tax-exempt fund.
Money Market Deposit Account
A money market deposit account is like a savings account. You deposit money and it grows according to a fixed rate of return. The return is taxable.
Money market funds and money market deposit rates are generally similar and each follows the same pattern of investment to spur growth within the fund. They simply invest in short-term, low-risk securities like treasuries and bonds. To find the best money market rates, be sure to compare both types of vehicles.
When looking for a money market savings rate, the actual rate you're quoted is only part of the benefit of investing in that vehicle. In fact, in a volatile market, a money market account offers a perfect fixed hedge for your retirement or other brokerage account.
What is a hedge?
All investments present a certain amount of risk. The way that you can combat that risk is to invest in different types of risk. In doing so, you create a small amount of protection against loss, because as one investment goes down, another may go up or at least remain stable. This counterbalance is considered a hedge.
How do money markets hedge?
Money markets are fixed investments, so you aren't going to lose money when you invest in them--unlike stocks and mutual funds. That means that, while all your other investments could lose money, a money market will not and will continue to experience small gains. That hedges you against complete financial ruin.
So consider a money market account for your short-term savings and for a small portion of your long-term savings in order to help you hedge against loss to some degree.