“I have money going to my savings account each paycheck that I don’t know what I should be doing with; what should I be doing with it?”
Let’s start with the ever-important caveat that personal finance is personal, and as always, “it depends.”
With that out of the way, let’s talk about some ideas, habits, and strategies you should be thinking about if you feel like you’re sitting on too much cash.
It may seem trivial at this point but having a sizable cash reserve is crucial for many reasons, some of which provide a “hidden return” like having the flexibility to search for better job opportunities or be more selective with investment opportunities.
At a minimum, you should have at least three months worth of living expenses in cash at all times. This should range as far as eighteen months of cash reserve depending on a variety of factors such as if you’re self-employed, how economically sensitive your job is, or how many income sources you have in your household.
Personally, I strive to have twelve months’ worth of living expenses in cash as it provides me the peace of mind to run my business and invest (in personal investment accounts) long term with confidence.
If you’re still working towards building towards your ideal cash reserve, don’t feel bad about not investing additional cash flow. The opportunity cost of building a sizable cash reserve is well worth the peace of mind.
When you’re determining your ideal cash reserve, you can base it on your baseline spending needs or what you’re currently spending. The lower your baseline spending needs, the lower your cash reserve can be, and in turn, the more cash flow you can use to grow your net worth on an ongoing basis.
If you’ve determined you’re “sitting on too much cash” relative to your cash reserve requirements, here are some things to consider:
Are there any major short-term expenses or purchases you anticipate to have in the next 6-18 months? Generally speaking, you want to avoid investing in the stock market for any money that will be needed within the next three years (ideally five years +). However, if you have a sizable cash reserve, stable income, and a high tolerance for risk, there is some flexibility.
If you don’t anticipate having any major short-term purchases and are looking to maximize the value of your hard-earned money to grow your net worth, here are some ideas:
Are you maxing out your 401(k) at work? You can contribute up to $19,500 (under age 50) in employee contributions for 2020 and 2021. Why would you want to contribute more to your 401(k) than is necessary to receive your employer match? Because contributions to a Traditional 401(k) reduce your taxable income and can be invested to grow tax-deferred until you need to pull them out after age 59 1/2. If your employer offers Roth 401(k) contributions, you should strongly consider taking advantage of these “after-tax” contributions (no income tax deduction) to increase your tax-free investment assets.
In addition to maxing out your 401(k) at work, you should also be taking advantage of an individual retirement account (IRA). You can contribute up to $6,000 (under age 50) for 2020 and 2021 and receive the same tax-deferred benefits as investing in your 401(k). However, if your income (MAGI) exceeds ~$124,000 (2020), you’ll want to consider a backdoor Roth IRA.
Does your employer offer a Health Savings Account? You’ll need to have chosen the “high deductible” plan to take advantage of the account. HSA contributions are a no-brainer as they provide a potential “triple tax-free” benefit. Contributions to the account reduce your taxable income, can be invested with tax-deferred growth, and if used for a qualified medical expense, can be distributed tax-free Additionally, if the money can be drawn penalty-free after age 65 for any reason. An extremely tax flexible account to take advantage of if you have access!
If you’re taking advantage of all your tax preferential accounts and still have additional cash flow, you should consider investing in a taxable brokerage account. The specific investment selection should align with your overall investment strategy. Meaning, you should invest in a taxable account that factors in your investment holdings across your various retirement accounts.
A taxable account is more flexible in that you always have access to the money penalty-free. However, unlike a retirement account, you’ll be subject to taxes. Consider holding most of your equity allocation in your taxable account (as it grows in proportion to your other accounts) as stocks will have more tax flexibility with capital gains and/or tax-loss harvesting.
If you’re sitting on too much cash, the most important thing is that you have a plan for how to maximize the use of additional cash on hand. Getting in the habit of investing regularly is the most important factor for achieving long-term financial success as it puts the odds in your favor.
Although cash is safe in the short-term, it becomes risky long-term as the purchasing power is eroded from inflation. Make sure you’re doing all you can to preserve (and hopefully grow) your hard-earned wealth.
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