By Dr. Jim Dahle, WCI Founder
I get occasional emails from people who are worried about investing “unsettled funds.” I think the main problem is that Vanguard (and probably other brokerages) flash up this huge warning when you put in a buy order using unsettled funds. Seeing that thing unnerves me every time, even though the orders always work out just fine. That scary message probably reads something like this:
“Please be aware that you are using unsettled funds for this purchase. It is considered a trade violation under Federal Reserve Regulation T when unsettled funds are used to make a purchase and the security purchased is subsequently sold prior to the settlement date of the funding sale. To avoid a trade restriction being placed on your account, you must either avoid selling these shares before the funding sale has settled or deposit additional funds into your settlement account to cover the amount of the purchase. Please call 877-662-7447 if you have any questions.”
What Are Unsettled Funds?
When you sell a stock, bond, or ETF, there is a trade (transaction) date and a settlement date. They are not the same thing. For the most part, all you need to pay attention to is the trade date. That's when you start owning the security (or stop owning the security). That's what matters when it comes to your returns and when dividends are paid. However, investments have to “settle.” That's when a trade is finalized. The period between the trade date and the settlement date is the settlement period. Until the trade is fully completed, those funds are considered “unsettled.”
History of the Settlement Period
In 1975, Congress directed the SEC to establish a national clearance and settlement system to facilitate securities transactions. Beats me what they did before. Maybe every brokerage or exchange had its own process, I don't know. But starting in 1975, the SEC made a bunch of rules, one of which was that trades settle five days after the trade date. This was known as “T+5.” This gave the buyer and seller time to take care of all the necessary tasks of the sale, such as physically delivering stock certificates and/or money. I know, it all sounds bonkers in our day and age of instantaneous trades, money transfers, and a lack of physical stock certificates. But due to those nearly 50-year-old rules and as a convenience to the industry, the settlement period remains in effect. In 1993, the period was shortened to three days (T+3), and in 2017, it was shortened to two days (T+2). This is the law currently in effect.
If you make a trade on Monday, it settles on Wednesday. Make a trade on Friday and it settles on Tuesday (assuming no Monday holiday) because we only count trading/business days. In May 2024, the settlement period will be shortened to one day (T+1).
Note that under our T-2 system, not everything settles two days later.
- Stocks: Two days
- ETFs: Two days
- Corporate Bonds: Two days
- Municipal Bonds: Two days
- Foreign Exchange: Two days
- Government Securities: One day
- Options: One day
- Commercial Paper: Same day
- Certificates of Deposit: Same day
The main benefit of a shorter settlement period is that brokerages don't have to hold so much cash, which can lead them to limit trading during market frenzies.
What About Mutual Funds?
Mutual fund trades occur at the end-of-day price. However, their settlement period can vary from 1-3 days. Generally, if you stick with one fund family such as Vanguard, they will settle the next day.
More information here:
The Case for Mutual Funds
Do I Have to Wait Until the Funds Settle?
Where people get confused is when they sell a security. Let's say they sell $10,000 worth of an ETF. Now, they have $10,000 in cash. This cash is unsettled, but it is available to trade. The brokerage probably isn't going to let you withdraw it, but it will let you buy another ETF with it immediately. Let's say you were tax-loss harvesting from VTI to VOO. You'd sell VTI. Then, you'd buy VOO. Both trades would settle in two days. The cash to buy VOO came from the sale of VTI. No problem.
Same thing when you exchange mutual funds. You put in the exchange order. At 4pm ET, the sale and purchase occur. They both settle a day later. No problem.
What About Swapping from a Fund to an ETF?
If you're going to be tax-loss harvesting your taxable account, you should generally stick with either ETFs or mutual funds for a given asset class. Then, the settlement dates will always line up just fine. But if you're switching from one to the other, you can run into problems. There are two reasons for this.
The first is that the ETF transaction takes place during the day, but the mutual fund transaction takes place at the end of the day. You may be selling low and buying high. That's bad. (You might get lucky and have the opposite occur, of course.)
The second problem involves differing settlement dates. This probably isn't an issue if you're selling a Vanguard fund at the Vanguard brokerage and buying a Vanguard ETF on the same day. The fund sale will settle the next day, and the ETF purchase will settle the day after that. But if you are selling a fund with a three-day settlement period, you could get burned.
What About Swapping from an ETF to a Fund?
Here's where you run into trouble usually. If you sell an ETF (settles on T+2) to buy a fund (settles on T+1), there isn't going to be any cash in the account on T+1 to buy the fund. So, don't do that.
More information here:
150 Portfolios Better Than Yours
You Should Invest Like a 50-Year-Old Woman
What Are Trading Violations?
There are a number of trading violations you should know about. Let's discuss each.
Freeriding
Freeriding is when you buy and sell securities in a cash (not a margin) account without ever having the cash in there. If you buy $1,000 of an ETF and then sell it later that day for $1,025 but never actually have $1,000 in the account, you have engaged in freeriding. On the other hand, if you transfer $1,000 into that account so it's there by T+2, there is no problem. The penalty for freeriding is a 90-day restriction on the account where you can only buy and sell using settled money.
Liquidations of an Unsettled Trade
This occurs when you sell a security purchased with unsettled funds before the settlement date. For example, if you sell an ETF on Thursday and then buy a different ETF on Friday, no problem. But if you then sell that second ETF on Friday (before the Thursday sale ever settles), you have liquidated an unsettled trade. Do that three times in a year, and you'll have the same 90-day restriction as a freerider on the account.
Late Sales
Late sales, also called trade liquidations, are what happens when you don't get settled money into the settlement account on time. For example, if you buy an ETF on Wednesday and use the proceeds from an ETF sale on Thursday to pay for it, the money to pay for Wednesday's purchase won't be settled on Friday, the settlement date for that trade. The brokerage can see it's coming, but it's not there yet. Do this three times in a year, and you'll get a 90-day restriction on trading unsettled funds in the account.
Don't Expect a Warning
While Vanguard warns you when you buy using unsettled funds (not a violation), it DOES NOT warn you when you then sell something you bought with unsettled funds (the actual penalty). I know, it doesn't make sense, but that's the way it is.
More information here:
The Ethics of Investing
Avoiding Violations
You can easily avoid these violations by understanding settlement periods and by being careful—or you can just hold plenty of cash! But if you want to avoid that cash drag, be sure to keep an eye on all of the following:
- Be sure the settlement fund balance will cover the trade before you make the trade, including commissions and potential market fluctuations.
- Be sure you choose the right account. Money in one account can't settle a trade in another one.
- Correctly identify your settlement fund. Not all money market funds are settlement funds. You might have to sell shares of a money market fund into your settlement fund to cover a trade.
- Look at the funds available to trade (includes unsettled money) and funds available to withdraw (settled money only) before making trades.
- Be sure to get mutual fund (including money market fund) sell orders in before the end of the trading day if that is how you are funding a security purchase.
- Don't put in sell orders on securities that have not yet arrived in the account. There could be a delay in their arrival. Just like the money has to be in the settlement account on the settlement date, the securities have to be in the brokerage account.
- Open a margin account. If you don't have enough in the settlement fund to cover the trade, you can still use your line of credit.
- Don't buy and sell frenetically. Especially take note when buying a security using unsettled funds. It's OK to do this, so long as you don't resell that security too quickly. If you only tax-loss harvest every couple of months and don't day trade or market time, you're never going to have any issues with this.
- Know the settlement dates of various securities.
What About Cash Transfers?
You know how banks sometimes don't let you access the entire amount of a big check you deposited for a few days? Yeah, brokerages don't seem to have a big problem with you spending money on securities as soon as it arrives. If you put in an order to transfer money to your settlement fund from your checking account, that money is basically instantly available to make purchases. Convenient, right? No need to wait a couple of more days until you're sure the money is there before getting it invested. Just be careful not to “bounce the check.” Don't expect the brokerage to let you withdraw/transfer/wire that cash somewhere else for a few days, of course. It'll need to settle before you withdraw it, and that could take up to a week.
Wait — Those Penalties Aren't So Bad
You're right. With two of the violations, you have a three-strikes rule, and those strikes reset after a year. And even if you have a violation, it's not like you can't trade anymore. You just can't trade with unsettled funds for a few months. No big deal.
Trading your life savings seems scary. Things like “trading violation warnings” don't help. But once you understand what is going on, you'll feel a lot more comfortable managing your own money, potentially saving you thousands of dollars per year.
What do you think? Ever committed a trading violation? What happened? Comment below!
