Say you’ve got a little extra cash. Now you have to decide whether to save or invest it. The answer, surprisingly, doesn’t come down to how much money you have. These days, when you can jump into investing on an app with no transaction fees and low ongoing costs, you don’t need to have a big, round number like $1,000 or $5,000 before you can invest.
“The key number is time, not a dollar amount,” says Stuart Ritter, retirement insights leader at investing company T. Rowe Price. The simple rule: If you need the money in the next three years, then save it. As soon as you decide that the money will be used after that time period, then start thinking about investing in something that will grow more, like stocks or bonds.
This is important to consider because it comes down to risk. When you put money in a savings account, you’re guaranteed to maintain the balance you deposited, plus a small amount of interest, and the funds are insured in the unlikely event your bank ends up failing. Most important, you can use the money anytime you want without worrying about losses or ending up with a tax bill.
In today’s economic environment, however, the interest on savings doesn’t go very far. That’s why so many people who’ve never invested before are considering it now. Even as rates climb, savings account interest rates still lag inflation, and so the money you keep in those accounts may not keep pace in the long term. A dollar today may only buy the same amount as 82 cents in 10 years, if the inflation rate averages 2% a year. It may buy even less if inflation stays high for some time.
On the other hand, investing is not a guaranteed return. While you’ll have protection akin to FDIC insurance for institutional failures, you won’t be protected against loss if your holdings go down in value. The stock and bond markets are often volatile, and you have to be prepared for the reality that you may lose money—even a percentage point drop in a day could be significant to you.
“It’s important to understand there’s no free lunch,” says Ritter.
So how do you decide what to do? There are dozens of different accounts and financial products to choose from. We talked to financial advisers to help make sense of it all. Your first step is settling on a goal. Then you pick the account that will help you meet it. Read on to find out more.
For money you need this month
Your strategy is: Saving
The tool you need: Checking account
Here’s what to do now: Put money for your day-to-day spending and bill-paying here. “That money should be your transactional monthly spending, but not much more,” says Mike Reust, president of Betterment, a registered investment firm. But you also don’t want to play it too close to the edge and incur any fees for overdrafting. Even as many banks have scaled back on onerous charges for not having enough cash to cover your purchases, there may still be some penalties. The key to this is to track your budget, either with a do-it-yourself budgeting method or an app that can help you keep track of your finances, and then assume you’ll need to have at least 25% beyond your monthly needs just to make sure you can cover your checks.
For six months of emergency savings
Your strategy is: Saving
The tool you need: High-yield savings account
Here’s what to do now: Set aside three to six months in cash for emergencies, which is the amount experts recommend. Some people may want to keep more: “Early retirees, especially, like to have up to two years of cash on hand,” says Rose Swanger, a certified financial advisor from Nashville, Tenn. That’s because they have less time to wait for markets to rebound. If retirement is much farther away, you may want to keep a bare minimum in this account, and invest more for the long-term.
You should also automate your savings, which is a powerful psychological tool. You can direct a portion of your paycheck into a savings account, or you can set up an automatic deduction once it hits your checking account. “Money you don’t see is money you don’t spend,” says Swanger. She recommends keeping your high-yield savings account at a separate bank from your checking, so it’s even further separated from your regular spending.
For big expenses in two to three years
Your strategy is: Saving
The tool you need: CDs, I Bonds
Here’s what to do now: If you’re planning on buying a house in a couple of years, you’ll of course want to do something different with your money than if your goal is to pay for your child’s college in 18 years. Again, it’s all about your timeline. For an interim goal that is longer than just emergency savings, Nolte suggests considering a certificate of deposit, or a series of these that you buy as you save up for individual purchases like a new car or a big trip.
You can open an account online with a few clicks directly from most banks or investment brokerages, like Fidelity or Chase. Your money will get locked in for the time frame you select, from three months to several years. Nolte also suggests looking at I Bonds, which are offering high returns right now because they’re correlated with inflation. You buy these directly from the government, and your money is locked in for one year, with small interest losses for withdrawing before five years.
For money you’ll want to spend in about 10 years
Your strategy is: Investing
Tools: Brokerage account
Here’s what to do now: If you have your monthly expenses covered, plus six months of emergency savings tucked away, and you still have cash you don’t need to tap into for a decade, investing can be a good choice.
Your first step should be to assess your feelings around money and risk. You can take a risk tolerance survey to match your psychology to your strategy. Nolte finds this question useful: “Would it bother you more to have 100% in cash and see the market go up, or have 100% in the market and see it go down 29%?”
Knowing your risk helps you choose a portfolio, which could be 60% stocks and 40% bonds, for instance, or some other configuration. “If you’re 22, your time horizon for retirement is so long that what happens in a short period of time is irrelevant.” says Ritter. “You’ve got 40+ years, so it all gets invested in stocks.”
Securing your future retirement
Your strategy is: Investing
The tools you need: 401(k), 403(b), IRA
Here’s what to do now: If you’re working, make sure you’re using an account like these to save for retirement. The goal is to fill your 401(k), or other eligible workplace plan like a 403(b), and contribute at least as much as your company matches, says Nolte.
Consider setting up the feature that automatically escalates your contribution level every year, usually by 1%. Anything you don’t have to think about will help you. “If the boss matches you at 4%, then save at least 5%—that’s one day’s lunch money,” says Swanger. “When I get clients to do this, a year later, they don’t even feel they’re putting money into saving.” She adds: “That’s when I say, then increase it by 2% or even 3%.”
If your company doesn’t offer a plan and you have earned income, you can start your own IRA or Roth IRA at an investment firm and invest up to the yearly limit set by the IRS. There are also various options for self-employed retirement accounts that have higher limits.
Swanger’s advice is to keep these investments simple. Her general rule is that if you have $100,000, it should be in just two or three funds, like a general stock fund, a bond fund and an international fund. For one thing, each investment comes with its own fees, and you could owe taxes every time you transact, even if you’re not paying cash just to trade.
Even if retirement seems a far-off goal, you’ll benefit from compound interest—fill your numbers into this calculator to see potential future earnings—by using these accounts.
This article was originally published in The Wall Street Journal on September 28, 2022, and written by Beth Pinsker.
- Image courtesy of iStock
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