Most investors think that whenever you buy or sell a security the money is immediately deducted or deposited into your account. This is not true.
Although the results of the trade may look as though they have taken place, the money is not actually due until the settlement date.
Mutual fund trades settle in one day and must be made before 4pm. The mutual fund companies then use the pricing of assets as of 4pm to set the share price for the assets they own and then determine how many shares each new investor is purchasing for the deposit they are making and how much money each shareholder who is selling shares should receive. The money is debited or deposited the next day.
While most mutual fund trades must be made before 4pm, some mutual fund companies require a 3pm deadline at other brokerage companies. The most notable one that we work with is Vanguard. Purchases or redemptions of Vanguard shares must be made before 3pm at Schwab so that Schwab can transmit these to Vanguard before the 4pm deadline.
Trades for stock or exchange traded funds take 3 days to settle. Stocks and exchange traded funds trade throughout the day on the open market. When you buy a stock the order is either settled by matching your order with someone interested in selling their shares or else by the market maker fulfilling the order and selling you shares from their own inventory.
For every stock or exchange traded fund on the exchange, at least one company must agree to be a market maker and always be willing to buy or sell shares. They must offer shares for sell at an asking price and be willing to purchase shares at a lower bid price. The difference between these two prices is called the spread and is how market makers make money when they are the only ones willing to buy or sell shares.
When a stock or exchange traded fund is traded, the cash is due or delivered three business days after the transaction. If you sell a stock on Friday, the trade won’t settle until the following Wednesday.
Understanding settlement dates matters for at least several reasons.
If you need money from your brokerage account as quickly as possible, it matters what you are selling in order to generate the cash. If you sell a mutual fund the money is available the next business day. And if you use an electronic Money Link to transfer the cash to your local checking account that takes one more night to transfer. Thus, when you are selling a mutual fund, the cash can be in your checking account in two days. But if you are selling a stock or exchange traded fund it might take four days.
Normally, if you sell one stock and purchase another, the proceeds from the sale will be delivered in time for the purchase you have made since the settlement date of both is in three days. Similarly if you sell a mutual fund and purchase a stock, the proceeds from the mutual fund is delivered in one day and the money to purchase the stock is not due until two days later.
Because the settlement date is different for mutual funds and exchange traded funds though, if you sell a stock or exchange traded fund and are using the proceeds to purchase a mutual fund you may not have the funds from the stock in time. The money from the sale of the stock won’t be available for three days but the cash used to purchase the mutual fund is due in one day.
This can cause the account to temporarily have insufficient funds. This can cause either a trade settlement violation or margin alert. At Schwab, the brokerage we use, it will not cause any of those problems so long as all the trades are made on the same day.
If the trades are made on different days though, it causes a trade settlement violation. For example, if a stock is sold on Monday and a mutual fund is purchased on Tuesday, it will cause a trade settlement violation. The money for the mutual fund purchase is due on Wednesday but the money from the stock is not available until Thursday.
This situation can easily arise when making trades between 3pm and 4pm. Vanguard mutual fund sell orders are due by 3pm while the market for stocks and exchange traded funds are open until 4pm. If you put in a Vanguard mutual fund purchase and an exchange traded fund sale after 3pm, the Vanguard trade will not be executed until the next day. Since the trades were not all made on the same day this can cause a trade settlement violation or margin alert because the money from the mutual fund will be due a day before the proceeds from the exchange traded fund settle.
Settlement dates is one of the reasons we default to including the option of margin on taxable brokerage accounts. If there is any problem with the settlement dates, margin can cover the deficit for a day or two. Margin cannot be put on retirement accounts, however, and a trade settlement violation would occur.
There are a few account types, such as self-directed 401(k) accounts, which are restricted to cash up front. These accounts require that the cash be fully available before any purchases are made. For cash up front accounts, if you sell a stock on Monday you cannot use those funds to purchase anything until they settle 3 days later on Thursday.
Rebalancing in cash up front accounts requires making purchases 3 days after you have made sales.
Settlement date is a small issue which if not understood can have surprising effects.
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