Optimizing your savings
Have you built up some extra cash? Great job! But don't just stop there -- be sure that your savings are being maximized. Here are a few key steps to figuring out what to do with the cash you've accrued:
- Hold only the right amount of cash
- Choose the right accounts
- Use passive investing to maximize returns
Hold only the right amount of cash
Cash is great for a few things: everyday expenses, emergency funds (which we define as enough to cover three to six months of living expenses), and goals that are coming up in the next five years.
Holding any extra cash on top of what you need in the near term is known as "cash drag" — cash that is underperforming compared to what you could make if that money were invested. History shows that financial markets rise over the long term, so excess liquidity means you could be losing out on some valuable returns.
To illustrate the downside of cash drag, let's compare how $10,000 extra cash would grow in a high-yield savings account versus if it were invested.
Source: Wealthfront; assumes $10,000 initial deposit, 5.76% annual market return and 2% annual return for high-yield savings.
According to the above scenario, investing in the market for 30 years could leave you with close to 3 times the amount you’d have at the end of the period than leaving your cash in a high-yield savings account. Leaving your cash that isn’t earmarked for short-term goals in a savings account is, in reality, making a choice to take a lower return. Be intentional with how you allocate that savings because it can have a real impact on its future growth.
Choose the right account for your savings
For short-term goals
As we mentioned above, for an emergency fund and short-term goals (less than five years), it makes sense to hold cash rather than invest it in the markets. Because there is volatility in the markets, you could suffer losses in the short-term and not have cash on hand when you need it. But not all accounts for your short-term cash are created equal. The interest rates of checking or savings accounts can vary widely from a measly 0.01% to a much more attractive 2%. For your short-term cash needs, we recommend using a high-yield savings account with a high interest rate because it allows you to earn a some return without taking on market risk.
For long-term goals
The rest of the savings that you're holding for long-term expenses (five years or more) should be invested in the market. Which account you choose to invest this cash depends on your goals.
Consider specific tax-advantaged accounts if you're:
- Saving for your kid's college: Experts consider 529 plans the best way to save for college because of their superior tax benefits and relative flexibility. Learn more →
- Saving for retirement: Consider contributing to a 401(k) if your employer offers matching contributions. Otherwise, an IRA account could offer tax benefits to those who qualify. But in many cases, it may be more advantageous to put retirement savings in a taxable investment account. Read more →
For all other goals, like saving for a downpayment or growing your savings for future expenses, a taxable investment account is likely the best option for you because it's a flexible account without any withdrawal penalties.
Use passive investing to maximize returns
For long-term goals, we recommend passive investing, which means putting your money in a diversified portfolio of low-cost index funds. Year to year, one asset class may rise and another may fall. But by investing across asset classes you can insulate yourself — to some extent — from losses while tracking the broad performance of the overall markets.
This strategy should be coupled with a "set it and forget it" mindset. In other words, we strongly urge you against trying to time the market. A huge strength of passive investing is that it leaves human judgement and emotion at the door and lets your money steadily compound over time.
Good investing is built on three important principles: diversification, minimizing fees, and minimizing taxes. To learn more about these principles, as well as the historical data and academic research that support passive investing, read more here.
TO SUM IT UP
Building up your savings is a great first step, but it's equally important to be mindful about where you put that cash. Choosing the right account can have a significant impact on your return and your taxes. So be sure to optimize your savings by making sure your money is working as hard for you as possible!Dive into another question →
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