A sweep account allows you to maximize your interest income on money normally idle by transferring funds from a non-interest bearing account to an interest-bearing account automatically.
Businesses and individuals often have monies in their checking account earning no, or only a token amount of, interest. A sweep account automates the process of transferring money to the interest-bearing account.
It should be noted that better options are sometimes available, depending on your situation. A variety of safe, and even guaranteed, cash management tools exist for investing short-term monies. We will explore the benefits and pitfalls of sweep accounts in this post and when to consider alternatives.
Where Can I Find a Sweep Account?
Banks, credit unions, and brokerage firms usually have sweep accounts available.
What Are the Benefits of a Sweep Account?
The primary benefit of a sweep account is the earning of interest on idle, unproductive money.
The sweep account is also an automated process. At the end of each day the bank or brokerage sweeps the funds in the checking or brokerage account to an interest-bearing account. Money can be transferred back to the original account during normal business hours.
Some brokerage firms add interest to money on account without moving the money to another account. However, sweep accounts pay more interest and should be explored.
The amount of funds involved plays a role at some financial institutions. Large dollar amounts at banks may get preferential treatment. Individual and business accounts may have different options.
What Is the Downside of a Sweep Account?
Several issues should be considered when setting up a sweep account.
First, money is swept into the sweep account each day. If you wish to return the money to your checking or brokerage account you need to make a manual transaction. Some financial institutions will automatically transfer funds back to the original account when the balance falls below a preset minimum. This is not a guarantee. You must verify the financial institution’s policy on this option.
Another downside of certain sweep accounts is fees. The idea of the sweep account is to earn interest on excess monies. If the excess is small, fees can take a large portion of the benefit. Fees can either be a flat monthly fee or a portion of the interest earned. Many sweep accounts exist that do not charge extra fees and should be considered before sweep accounts with fees.
While sweep accounts are automatic, and therefore convenient, they are not always the best option. For example, E*TRADE has a cash balance program for its brokerage accounts that pay virtually nothing (.15% for accounts over $1 million as of this writing). Additional sweep account options are available that currently earn a 4.24% 7-day yield. The E*TRADE link has up-to-date rates.
If you don’t want the lower sweep account rates you can transfer funds within E*TRADE to the Vanguard Federal Money Market Investor (VMFXX) paying a 4.57% 7-day yield. The transfer to the Vanguard money market is not charged a fee by E*TRADE. If the amounts involved are large enough the alternative VMFXX investment may be a better choice. But the money market is not technically a sweep account and transfers are not automatic. A manual entry is needed.
Another downside of sweep accounts are the choices available. Most sweep accounts are liquid, meaning you can access funds at any time. You still need to verify there is no holding period involved on the sweep account or your checking account. Since banks often have a holding period when businesses deposit customer checks, the sweep account is not a way around the holding period. There can be a delay on funds transferring from the checking account to the sweep account, and back. Also verify how fast money transfers back to the original account. Normally transfers are instant or at the end of the day at the latest. But you need to verify to assure your money management plan meets your needs.
What Are the Risks of a Cash Sweep Account
Sweep accounts are designed to be safe and liquid. However, this is not a guarantee.
Liquidity is a large risk. In most cases your money is always available. You can, if allowed, spend the money right from the sweep account or transfer the money back to the original account to fund investments or pay bills.
There have been lawsuits against financial institutions offering sweep accounts. Often the lawsuits revolve around the rate of interest paid. As we noted above, with E*TRADE as an example, sweep accounts can pay paltry sums. That is why we consider alternatives, when available.
A sweep account can have guarantees, but that is not always the case. Verify if this is a concern. Money market accounts, as an example, might not be covered by FDIC. If the money market account is a deposit account at a bank it is covered by FDIC. The afore mentioned VMFXX is not.
Another risk to consider is lost-opportunity cost. Money in a sweep account can be out of sight, out of mind. A forgotten account at a bank or brokerage seldom used means an opportunity to invest might be lost.
The ultimate risk of sweep account investments is not using a sweep account in the first place. Earning 0% on idle money is not a winning strategy. Money not earned is never caught up.
Can I Lose Money In a Sweep Account?
If the account is an insured bank deposit the account is guaranteed by FDIC. However, not all accounts are insured.
VMFXX is not an insured money market account. Still, money market accounts are designed to remain stable at $1 per share. Interest is paid out monthly. However, you earn interest for money invested for any portion of the month. Investments inside a money market account are very conservative and present low risk.
Unless a sweep account is offering an interest rate well above market rates at the time, it is likely the sweep account is invested in safe investments. It is possible to lose money in an uninsured sweep account. However, it is an unlikely event.
Are Sweep Accounts Taxable?
Probably.
Depending on how the sweep account invests the funds, the interest earned is likely taxable. However, there are government money market sweep accounts where some or all of the interest is excluded from state income tax. There are also tax-free sweep accounts that pay lower rates due to their investment in municipal bonds. Some or all of the interest earned in these sweep accounts can be excluded from federal and state taxes. In reality, at least a portion of the interest earned will be included in taxable income for most businesses and individuals.
Generally, sweep accounts at banks are taxable unless otherwise noted. At brokerage firms there are often times options that exclude some of the interest earned form reportable income. Due diligence is required.
Final Sweep Account Tips
Sweep accounts are a powerful tool for businesses and individuals. This is free money often left on the table because people either don’t know about the tool or neglect to set the process in motion.
When I consult with clients sweep accounts are often mentioned because I see money sitting idle earning no interest. Often I encourage alternatives, too.
You might think we are dealing with small numbers. Not always true. I have had clients with 7-figures in a checking account earning 0% when all they need is $200,000 in working capital. All the money in a checking account could go to a sweep account, or at least $800,000 to a sweep account alternative. You can easily see we are dealing with serious money.
But what about non-businesses? People? The same rules apply. The numbers may not be as large, but the rules are the same. Using a sweep account for all your idle cash sitting in your checking account can add up to nice money. Even small amounts add up. If you normally have $10,000 in your personal checking account and a sweep account earns 5%, you have an extra $500 at the end of the year.
Every brokerage account should have the sweep account option set up or, if you prefer, a manual alternative you stay consistent with.
If you haven’t already, you need to talk with your bank about setting up a sweep account for your checking, and any other non-interest bearing, accounts at said institution.
Sweep accounts are simple and fast to set up. The extra interest you earn is like manna from the sky. When interest rates were hovering around 0% there was little incentive to use sweep accounts. Those days are over. It is time to reinstitute a powerful cash management tool for your personal and business monies. It is how the wealthy manage their money.