How to Invest Money For the Long Haul – And Save In the Short Term
"As a financial advisor, I always recommend starting with an emergency savings fund, as it's vitally important to build up at least three to six months' worth of living expenses in case of unexpected events,” says Rosalyn Glenn, a financial planner at Prudential in Columbia, South Carolina. "I'm partial to credit unions, as they offer consumer-friendly interest rates, but the emergence of online high-yield savings accounts is also a good option with their higher interest rates due to a lack of overhead."
Jake Falcon, founder of Falcon Wealth Advisors in Mission Woods, Kansas, also suggests setting aside three to six months of expenses. For those approaching retirement, he recommends having at least five to 10 years’ worth of income invested in cash, Treasury bonds, bonds, preferred stocks or similar vehicles.
"The goal is to have a consistent cash flow to weather the economic cycle," he says.
Saving For the Short Term
High-Yield Savings Accounts
As the name implies, high-yield savings accounts offer higher interest rates than traditional savings accounts. Numerous online banks, such as SoFi, Capital One and Goldman Sachs’ Marcus, offer these accounts.
"High-yield savings accounts are perfect for emergency 'rainy day' funds and planned expenses coming due within a few months," says Devin Carroll, owner and lead advisor at Carroll Advisory Group in Texarkana, Texas. "These accounts provide safety of principal while earning a higher rate of return than your standard savings account."
Certificates of Deposit
A certificate of deposit, or CD, is a type of savings account that holds a fixed amount of money for a set period of time, ranging from a few months to several years. Typically, the longest term is five years. In exchange for locking up your funds, you get a higher interest rate than a regular savings account.
The benefits of a CD include a guaranteed rate of return, which means depositors know exactly how much interest they’ll earn over the term of the CD.
Potential downsides include a lack of access to your money without penalty until the term of the CD is up. If you need to withdraw your funds early, you'll likely have to pay a fee, which cuts into your earnings. CDs also typically have higher minimum deposit requirements than regular savings accounts, which may be a barrier to entry for some.
Money Market Accounts
If you hold cash in your brokerage account, whether taxable or qualified such as an individual retirement account, it's likely in a money market account, or MMA. That's where brokerages tend to sweep excess cash, such as after the sale of a stock, and where cash goes if you transfer it from a bank account. You can also open a money market account at a credit union or bank.
Money market accounts typically offer higher interest rates than traditional savings accounts. This makes them an attractive option for holding short-term funds.
In addition, MMAs generally have lower minimum balance requirements than CDs, and there's no requirement to lock up your money for a set period of time.
MMAs sometimes offer check-writing privileges or ATM access, making them a convenient option for people who want fast and easy access to their funds.
Investing For the Long Term
When saving for retirement, you won't find a more convenient vehicle than an employer-sponsored 401(k) plan. Nonprofits or government entities offer 403(b) or 457 plans, which are very similar to 401(k)s.
Think of the 401(k) or similar plan as a box that holds mutual funds, and more recently, exchange-traded funds. As the account owner, you must choose which funds go into the box, though your selections will be limited to what your employer's 401(k) provider allows.
Employers frequently contribute a certain percentage of an employee's salary to their 401(k) account, up to a specified limit. This is often done to incentivize employees to save for retirement. It's also a benefit the company can tout when recruiting workers.
"It's important to take advantage of any employer match and ensure you're contributing to whatever the match percentage is," says Glenn.
Individual Retirement Accounts
IRAs come in two main flavors, traditional and Roth. There are some ways to add sprinkles on the top, such as opening an IRA for a spouse without earned income, but that's on the "advanced planning" menu.
A traditional IRA allows you to deduct contributions from your taxable income, which means you'll pay less in taxes now, but will owe taxes on the money when you withdraw it, after age 59½. You're required to begin making withdrawals no later than age 72, or 73 if you turn 72 on or after Jan. 1, 2023.
In contrast, a Roth IRA doesn't provide an immediate tax break but allows for tax-free growth and withdrawals in retirement. There's no requirement to make withdrawals at a certain age, but you must wait until you turn 59½.
"IRAs are very similar in tax treatment to a 401(k)," says Carroll. "Contributions may be tax deductible, and growth within the account is tax deferred. Because these accounts are an individual arrangement, the annual contribution limits are lower and your employer won't match."
Carroll says that retirees who only saved in tax-deferred accounts, such as traditional IRAs, often face large required minimum distributions, which result in high tax liabilities.
"This is where a Roth IRA is useful. Contributions to a Roth IRA are not tax deductible but will receive tax-free growth for qualified distributions," he says. "This is an extremely valuable form of diversification in retirement. The lack of RMDs during the original owner’s lifetime is an added benefit as well."
Charles Sizemore, chief investment officer at Sizemore Capital Management in Dallas, points out an advantage of IRAs. "Short-term capital gains are taxed at the highest possible rate, so running short-term trading strategies out of your retirement account makes sense," he says.
Nonqualified brokerage accounts do not have the same tax benefits as 401(k)s and IRAs. But they have a role in long-term investing. For example, if investors have maxed out their qualified accounts, they can put more into a nonqualified, or taxable, account. Sometimes people inherit money that's outside of a qualified account or sell a business or house. That money is not eligible to be put into a qualified account, as it doesn’t meet the earned-income requirement.
"Many advisors recommend nonqualified accounts as a last resort for saving due to the lack of tax-deferred growth, but they offer significant value within a portfolio," says Carroll.
He points out that while interest and dividends from nonqualified accounts are taxable in the year earned, unrealized capital gains can be left to grow until an opportunity arises to realize them at little or no taxation.
"This allows for the strategic capital loss and capital gain harvesting," Carroll explains.
Nonqualified accounts have other advantages, such as the lack of limitations on contributions, and the favorable tax treatment of long-term capital gains from these accounts.
"Ultimately, having diversification in asset location allows the savvy retirement planner to withdraw from multiple accounts at different sequences in retirement, smoothing their tax liability and minimizing cumulative taxes paid," Carroll says.