Here’s the scenario:  You hate the fact that the $30,000 sitting in your bank account is earning virtually nothing, but you’re also nervous about where the financial markets might be headed from here.  All of the money the government’s spending to resuscitate the economy is making you worry about inflation coming back with a vengeance at some point.

Historically, over the long term, the return on stocks has provided the best protection over inflation.  And, while they’ve had a nice run so far this year, how can you be sure it’s not a bear-market sucker’s rally?  Besides, you’ve already got a significant portion of your portfolio devoted to equities.  

You could park the $30,000 in Treasurys until the outlook clears, but the 1-year note is currently yielding a laughable four-tenths of one percent.  However, a 1-year certificate of deposit [CD] is paying around 2% -- fives times more.

Two percent isn’t going to make you rich, but at least you get the assurance of FDIC coverage.*  You’d get a full percentage point more if you locked up your money in a five-year CD, but if interest rates take off, your money would be stuck earning today’s lower rates until your CD matured.  Plus, you wouldn’t have access to it in an emergency (or if you need to buy a new car to replace your current clunker) without incurring a penalty.

The solution?  “Ladder” your CDs.  This involves dividing up the amount you want to invest among CDs with increasing maturities.  For example, if you chose 6-month intervals you might invest $5,000 in a 6-month CD, the next $5,000 in a 1-year CD, another $5,000 in a CD maturing in 18 months, and so on. 

One benefit of this strategy, according to Michael Goodman, a Certified Financial Planner and CPA in New York City, is that “the further you go out on your ladder, the higher the interest rate” your money will earn.

The intervals don’t have to be identical.  You could put some of your money in a 6-month CD and the rest in CDs maturing at annual intervals of one, two, three, four, and five years. 

Another advantage is that, periodically, one of your CDs will be maturing, giving you access to some of your money.  If rising inflation has sent interest rates higher, you can take advantage of this by reinvesting your money at the new, higher rate.

“If you feel strongly that interest rates are going up sharply, you might want to shorten your ladder,” says Goodman.  For instance, if you spread your CD maturities over just two years, they will “mature sooner and you [will be] able to get more of your money invested at these potentially higher rates faster.”

Laddering a portion of your retirement portfolio is a way to smooth out some of the bumps -- and angst -- caused by fluctuations in the financial markets.  In this case, you would move, say, three years’ worth of income into a series of CDs with maturities at increasing 6-month intervals, with the last one maturing in 3-years.  That way, you know the money will be there when you need it and you avoid having to liquidate investments at a time when the market might be down.

However, as Goodman points out, “CD interest is taxable.”  So if you’re not laddering inside a retirement account such as an IRA, income tax will eat up some of the interest you earn.  As an alternative, he suggests folks in higher tax brackets consider laddering triple-A-rated municipal bonds.  There’s no federal income tax on the interest they pay and in most cases, if the bond was issued by an entity within your state, you avoid state income tax, as well.

Just a couple of caveats: Munis don’t come with FDIC insurance, and you’ve got to have confidence in the companies that rate the safety of these bonds. (The same ones who failed to raise a red flag about  sub-prime mortgages.)

The current yield on a 2-year AAA-rated municipal bond is 1%.  For someone in the 35% federal tax bracket, that’s like earning 1.5% on a taxable investment.

If you happen to be one of Goodman’s clients and have the pleasure of living in New York City, your combined city, state, and federal tax burden is 47%!  Compared to a muni with a (city, state and federal) tax-free yield of 1%, you need to earn twice as much on a taxable investment in order to end up with the same amount of money in your pocket.

While the yield on ultra-short-term municipal bonds can’t compete -- even on an after tax basis -- with CDs right now, the picture changes dramatically when you go out 5-years.  A AAA-rated muni with a 5-year maturity is currently yielding around 2.25%.  To be equivalent, someone in the 35% tax bracket would have to earn roughly 3.5% on a CD.  Our upper-income New York City resident would have need a CD paying 5.5%.  However, 5-year CDs are only yielding around 3% right now. 

Buying individual municipal bonds is not for the inexperienced. In addition to evaluating the safety of the bond, you also need to identify whether it might make you subject to the “alternative minimum tax” [AMT].  So you’ll want to consider working with a tax and/or investment professional.

Or, as Goodman points out, you can invest in a high-quality municipal bond mutual fund with an ultra-short duration.  The manager will do the hard work of identifying the best candidates.  According to Goodman, “There will be fluctuation in the value of your account from month-to-month, [but] the chances of a loss in value are very small” -- partly because of the quality of the bonds and the fact that those owned by the fund are already very close to their maturity value. 

Plus, as bonds in the fund mature, the manager will automatically reinvest the proceeds at current interest rates, so you don’t have to worry about that either.  Mutual funds also have the advantage of being liquid. 

*Accounts at institutions covered by the Federal Deposit Insurance Corporation (FDIC) are temporarily insured up to $250,000 per account registration, per bank through December 31, 2013.  On January 1, 2014 the standard maximum FDIC insurance for bank accounts will revert back to $100,000, however IRAs and certain other retirement accounts will continue to be insured for up to $250,000.

If you have a question for Gail Buckner and the Your $ Matters column, send it to: yourmoneymatters@gmail.com, along with your name and phone number.