What Is a Sweep Account and How Does It Work?

Key Highlights

• A sweep account transfers excess funds from a checking account to an account that pays more interest.

• This transfer takes place at the end of every working day when there are excess funds available.

• Growing your money in a high-interest account without investing it in the stock market is one of the key benefits of sweep accounts.

• It is also possible to use sweep accounts for loan payments.

Sweep Account Meaning

Let us start with the sweep account meaning. A sweep account is a type of bank or brokerage account where excess funds automatically move into investment accounts that pay higher interest rates. The sweep takes place at the end of a business day. A sweep account may also transfer surplus cash for debt repayment.

The goal of these accounts is to make the most of money that is lying idle. They automatically move, or "sweep" it into an investment option with a better return. For instance, your sweep account may transfer unused funds to a money market deposit account or mutual fund.

How Does a Sweep Account Work?

To set up a sweep account, first mention a specific amount you want to keep in your checking account. Only the excess money at the end of the business day will be transferred. The extra amount is moved to a high-interest savings account or money market account.

On the other hand, money will be transferred from the investment instrument if your balance falls below the threshold limit. This ensures you have enough money in your checking account to prevent overdrafts.

How to Open and Operate a Sweep Account?

Opening and operating a sweep account is quite straightforward and can offer significant benefits for managing cash efficiently.

Steps to open a sweep account:

1. Research options: Begin by identifying financial institutions that offer sweep accounts, such as banks or brokerages. Compare their features, interest rates, and associated fees.
   

2. Application process: Visit the branch or website to complete the account opening formalities. Provide necessary documents like identification, proof of income, and banking details.
   

3. Select a sweep option: Choose the type of sweep arrangement you prefer. For example, surplus funds may be invested in money market funds, fixed deposits, or other instruments based on your financial goals.
   

How to operate a sweep account?

1. Monitor cash flow: The account automatically moves excess funds to generate returns, but regular monitoring ensures optimal utilisation.
   

2. Set limits: Define thresholds for transfers to ensure sufficient liquidity while maximising returns.
   

3. Review statements: Regularly check account statements to track performance and ensure all transactions align with your financial plan.
   

Example of Sweep Account

Let us now look at a sweep account example to understand how it works. Sagar has an auto sweep account with a Rs. 50,000 threshold limit. His checking account has a 6% interest rate. He has Rs. 40,000 in his account on November 10. Since his current amount is less than the Rs. 50,000 requirement, the money stays in his checking account. He continues to receive the monthly interest at a rate of 6%.

He deposited Rs. 60,000 on November 15th. So, his account balance increased to Rs. 1,00,000, which is more than the threshold limit. Therefore, the extra money beyond Rs. 50,000 will go into an investment account. Here, it is Rs. 50,000.

On November 30th, he withdrew Rs. 25,000. This brings his account balance down to Rs. 25, 000. However, he shall not lose his Rs. 50,000 investment.

Now, Sagar wishes to take out Rs. 30,000 from his account on December 3. However, his account balance of Rs. 25, 000 is insufficient. As a result, his checking account will receive Rs. 10,000 from the sweep account.

Types of Sweep Accounts

Sweep accounts may be categorised into the following groups based on their functions:

Money Market Sweep Account

To boost your profits, you can put the excess balance of your checking account into a money market sweep account. Money from your sweep account will automatically move into your checking account when the amount drops below a specific limit.

Loan Sweep Account or Credit Sweep Account

With this kind of sweep account, you may use the extra money in your checking account to pay back debts more quickly. Thus, business owners might benefit from a loan sweep account to pay off their obligations on time.

Personal Sweeps vs Business Sweeps

For individual investors, cash or dividends are frequently placed in a sweep account until they are ready to be reinvested. Usually, they transfer these funds to money market funds or high-interest accounts. This keeps going until the broker places permanent orders in the portfolio or the investor makes a new investment in the future.

On the other hand, businesses use a sweep account in a different way. They manage different payments and working capital through a number of accounts. So, by investing the money using the sweep system, they create additional revenue streams. They can also use this excess money for debt repayment.

Advantages of Sweep Accounts

The following are the key benefits offered by sweep accounts.

1. It helps you earn interest on your money: A sweep account enables you to transfer extra cash from a checking account into an interest-earning account.

2. Useful for debt and loan repayments: Instead of transferring the excess funds to an interest-earning account, you can use them for loan repayments. This will help you pay off debt easily.

3. Easy Liquidation: As an investor, you can easily sell your investments in the sweep accounts.

Disadvantages of Sweep Accounts

Here are a few drawbacks of sweep accounts.

1. Come with costs: You may need to pay fees for investing money that you transfer from a checking account to a brokerage account. To find out about all of your account fees, contact your brokerage.

2. Penalties: The biggest drawback of sweep accounts is the penalty for early withdrawal. Sometimes, the penalty may lead to less earnings than savings bank interest.

Are There Any Tax Implications of Sweep Accounts?

Sweep accounts can have tax implications depending on the type of investments where the funds are swept into, such as money market funds, fixed deposits, or other financial instruments. It is, therefore, essential to understand these implications to avoid surprises during tax filing.

1. Interest Income Tax: If the surplus funds are swept into a fixed deposit or savings account, the interest earned is taxable as "Income from Other Sources". The tax rate is based on your income tax bracket, and tax is deducted at source (TDS) at 10% for individuals with a PAN card, provided the interest exceeds ₹40,000 annually (₹50,000 for senior citizens).

2. Capital Gains Tax: If the funds are swept into mutual funds or equity-related investments, the returns may be subject to capital gains tax. Short-term capital gains (STCG) are taxed at 20%, while long-term capital gains (LTCG) exceeding ₹1.25 lakhs are taxed at 12.5%.

3. Tax Deducted at Source (TDS): TDS may be applicable on interest income from certain instruments and sweep accounts may be subject to these deductions. However, tax planning can help reduce the overall liability.

Who Should Use a Sweep Account?

Sweep accounts are a valuable tool for those seeking to efficiently manage cash flows while maximising returns on idle funds.

1. Active traders: Traders with fluctuating cash balances can use sweep accounts to optimise their liquidity. Any surplus cash in a trading account can be swept into a fixed deposit or other interest-bearing account, earning returns while ensuring funds are readily available for new trades.

2. Investors looking for safe, low risk returns: For those who prioritise safety and want to avoid market volatility, sweep accounts offer a way to generate returns from idle cash without taking on risk. The funds remain liquid, allowing quick access when an investment opportunity arises.

3. Hedge fund and fund managers: These professionals often manage large sums and may find sweep accounts an effective tool to ensure that excess cash is earning interest, even while awaiting the next move in the market.

4. Day traders with short-term cash: Day traders who require quick access to funds but still want to earn interest on their available cash will find sweep accounts ideal for parking funds between trades, providing the best of both liquidity and returns.

Conclusion

If you have several accounts, sweep accounts give investors a simple option to leverage their excess money. This allows money to automatically move from a checking account to a sweep account. The transfers occur at the end of the business day. There is always a chance of loss with brokerage accounts and varying returns. Yet, sweep accounts serve a crucial purpose by investing your money that is lying idle.

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