I'm setting aside money in my 401(k) every month, but also want to save up to buy a house in two years—plus build up my cash reserves in case I have an emergency—or even worse, lose my job. I'm unsure about where to keep these nonretirement savings. Can you help?
This is a really good question, and particularly relevant as we face a challenging inflationary environment. In general, people tend to give a lot more attention to stocks and bonds than they do to cash. That's certainly understandable, especially during the previous years when cash investments were making next to nothing. But now that interest rates have increased, and many accounts and cash investments are paying decent returns, it makes a lot of sense to pay close attention to our cash.
As you review your various options, your goal is to find the best tradeoffs between liquidity (how quickly and conveniently you can access your money), safety (the return of your money), and yield (the return on your money). This is definitely not one-size-fits-all. The best choices for you will depend on your time frame, appetite for risk and your specific goals. For example, you can decide to use a different account for your house savings as compared to your emergency savings or your everyday cash.
In general, the safer and more liquid the account, the lower the rate of return. As financial institutions tag on more restrictions and provide less protection, the higher the return. That said, there isn't always a perfect correlation between return vs convenience and safety, so it pays to shop around and read the fine print. Let's take a look.
Choices for your everyday and emergency cash
The goal of the following accounts is not to make a huge return, but to help you pay for day-to-day or emergency expenses. However, it still makes sense to try to get the biggest bang for your buck.
The following are all insured by the FDIC up to $250,000 per account holder, per bank, per ownership category and therefore very safe. The National Credit Union Administration (NCUA) insures checking and savings accounts at credit unions up to the same limits.
- Interest-bearing checking account—This is your working horse for everyday needs, allowing you to write checks and have easy ATM and debit-card access to your cash.
- Savings account—This is probably the category with the widest variation in features and yield, so doing some comparison shopping is well worth your time. These usually pay more interest than checking accounts but there may be restrictions such as limited withdrawals and debit-card transactions. To get the highest return you may also have to maintain a relatively high minimum balance.
- Money market account—Institutions are able to offer relatively high interest rates on these accounts by investing your money in high-quality, short-term debt. Like high-yield savings accounts, they likely have restrictions such as limited check writing privileges (over certain minimums) while generally providing higher yields than a checking account.
- Short-term certificate of deposit (CDs)—Offered by banks, credit unions and other financial institutions, CDs pay a fixed yield until maturity. Shorter-term CDs generally fall in the range of three months to one year; the longer the term to maturity, the higher the return. Penalties apply if you withdraw early.
Higher returns come with more risk
Alternatively, if you have a brokerage account, you could consider investing your money in a money market fund. Technically, these are a type of mutual fund that primarily focus on stability and capital preservation. The underlying investments are conservatively invested in very short-term IOUs. It's important to note that money market funds are not insured by the FDIC, although they are protected up to $500,000 per investor (with a maximum of $250,000 in cash) by the Securities Investor Protection Corporation (SIPC). They generally (but not always) offer higher yields than the accounts above.
Choices for money you won't need for several months or longer
- Longer-term certificate of deposit. If you know you won't need your money for many months or longer, you can consider purchasing a CD that matches your time horizon. In general, the longer the term, the higher the yield. These are federally insured, but be careful because you may be charged a penalty for early withdrawal.
- Treasury bills. Treasury bills mature anywhere between 90 days and 12 months, the longer the duration the higher the yield. Backed by the full faith and credit of the U.S. government. you can buy Treasuries either from a broker or directly from the government at TreasuryDirect.gov. Also of note, Treasury bills are exempt from state and local tax, so an especially good deal if you live in an area with both. One potential downside? You will miss out on some yield if you sell them before maturity.
- I bonds. Another potential option if you're willing to give up some liquidity is inflation-adjusted I bonds, which pay a relatively high yield based on the consumer price index, but must be held for a minimum of one year. Backed by the full faith and credit of the U.S. government, every citizen is entitled to purchase up to $10,000 of I bonds each year (plus, if you are due a tax refund, you can elect to get up to $5,000 of it in paper I bonds).
A possible scenario
With some smart shopping, you can find accounts that will help you grow and protect your savings. For example, you might choose to keep your everyday cash in an interest-bearing checking account, your emergency savings in a money market fund, and your house down payment in longer-term CDs.
While cash investments like these aren't the road to riches, they can serve an important role in helping you reach your financial goals. I remain a firm believer in the power of investing in the stock and bond markets to achieve long-term wealth. But for your important needs in the next few years, cash is king.