Is Your Cash Earning 5%? You might want to double check.

After over a decade of historically low interest rates, the allure of higher cash yields has attracted massive flows into money market funds, short-maturity US Treasuries (T-Bills), CDs, and high-yield checking and savings accounts. And what’s not to like about earning 5%?

But as the old saying goes, “All that glitters is not gold.” And for some investors, that 5% headline number ultimately ends up being much less—raising the question of whether there are better alternatives.

Sweeping Under Scrutiny

While higher interest rates have been a boon for investors with excess cash, it’s essential to understand what you’re actually earning. This is especially true when it comes to sweeping idle cash, a practice that has come under scrutiny of late.

What are sweep accounts? They were created as a clever way for banks and brokerage firms to circumvent regulations preventing them from paying interest on checking accounts. These accounts allow you to earn interest on excess funds that would otherwise just be sitting in your checking or brokerage account. Few investors would balk at putting idle to cash to work. Plus, if you’re already paying management fees on your brokerage account, a sweep account can help offset those costs.

The premise of a sweep account sounds appealing. But not all firms offer the same rates. In fact, multiple major brokerages and banks with wealth management businesses are currently facing legal challenges over their bank sweep programs. The heart of the issue? Instead of sweeping idle cash to higher-yielding accounts, some brokerage arms funneled client cash into low-yielding accounts at their affiliated banks. As a result, many clients earned well below 1.0% during a period when the Fed Funds Overnight Rate rose from nearly zero to 5.25%–5.5%.

So why would firms engage in such a practice? According to plaintiffs, it’s all about the bottom line. By funneling client cash into low-yielding accounts at affiliated banks, these firms were able to profit from the spread between the interest paid to clients and the higher interest earned by the bank when lending those funds. It’s a troubling trend that underscores the importance of transparency and fiduciary responsibility in the financial services industry. As an investor, it’s crucial to read the fine print and carefully consider where your cash is being swept and whether you’re receiving competitive interest rates on those funds.

How Taxes Fit In

If you believe your hard-earned money deserves to work just as hard for you, what are your other options? First, start with taxes.

While high-yield checking and savings accounts, CDs, and short-maturity US Treasury bills may offer attractive yields of over 5%, their tax implications matter, too. Interest earned on these accounts is taxed as ordinary income at both the state and federal level, meaning that top marginal federal taxpayers may only earn less than 3% after taxes. What’s more, state taxes can further eat into those returns, with a top marginal CA taxpayer taking home just ~2.3% after taxes.

So why have so many taxable investors flocked to these high-yield investments? It’s simple: everyone loves 5%. But those high yields come at a cost, and investors may end up paying a hefty price in taxes.

There is another option. Munis are bonds issued by state and local governments to fund public projects. The interest earned on municipal bonds is generally exempt from federal income tax and, in some cases, state and local taxes as well. That’s why a municipal money market fund could be a better alternative for certain taxable investors who need to maintain an allocation to cash.

When Muni Bonds Make More Sense

For investors in the highest marginal tax bracket, the tax-exempt nature of municipal bonds can result in a higher return (what you keep) versus taxable bonds offering pretax returns of 5%. For example, a taxable investor in the top tax bracket¹ who purchases a municipal bond yielding 4% would need to find a taxable bond yielding approximately 6.76% on a pretax basis just to break even on an after-tax basis. This makes munis particularly compelling for those seeking tax-efficient income.

In addition to their tax advantages, municipal bonds are considered relatively safe investments, especially when compared to taxable bonds. While they are not risk-free, the default rates on investment-grade municipal bonds remain historically low (Display).

Why Munis Now?

When it comes to high-quality bonds, there’s a simple rule of thumb: as interest rates rise, bond prices fall, and vice versa. This means that the value of municipal bonds can fluctuate depending on movements in interest rates. That’s where there’s good news on the horizon for bond investors. The Federal Reserves has indicated that their next move will likely be to cut interest rates, which should provide a boost to high-quality bond prices. And with many investors sitting on cash that won’t be earning 5% for much longer, history has shown that those who invest early are often rewarded with higher yields and greater price appreciation than those who wait until the Fed begins to cut (Display).

Many investors have gotten cozy with cash earning 5%. But it’s essential to look beyond the headlines. The recent sweep lawsuits against several banks underscores the importance of transparency and fiduciary responsibility. Ultimately, 5% on cash might prove to be too good to be true—and munis often make more sense.