Invest Or Save? Where Should Your Money Go?

Saving and investing are both critical components of a healthy financial plan. Saving is putting money away for future use, while investing is using that money to buy assets in the hopes of earning a profit over time. Both have their pros and cons, and it's important to know when to choose one over the other.

Saving is a good idea if you have short-term financial goals or need money for unexpected expenses. It's also a great way to build an emergency fund. The advantages of saving include low risk and easy access to your money. However, the returns are usually low, and your purchasing power may be affected by inflation.

On the other hand, investing is ideal for long-term financial goals, such as retirement or saving for college. It offers the potential for higher returns but comes with the risk of losing money. Investing requires discipline and a long-term perspective to weather market volatility.

Financial experts recommend having an emergency fund covering three to six months' worth of living expenses before investing. Additionally, investing money that you won't need for at least five years is generally considered a good strategy.

Emergency funds

The general rule of thumb is to save three to six months' worth of essential living expenses. This ensures that you have sufficient funds to cover unexpected costs and maintain financial stability. If you're just starting, aim to save at least $1,000, and gradually work towards the three to six months' goal. This amount can vary depending on your personal circumstances, such as whether you're single or have a family, and your financial obligations.

Where Should You Keep Your Emergency Savings?

It is recommended to keep your emergency funds in a safe, liquid, and easily accessible account. Here are some options:

• High-yield savings account: These accounts often provide higher interest rates than traditional savings accounts, allowing your money to grow while remaining accessible. They are usually FDIC-insured, protecting your funds. However, online-only accounts may have limited access and slower withdrawal processes.
• Money market accounts: These accounts are a mix between checking and savings accounts, often providing APYs of 3-4%. They are considered low-risk and are typically FDIC-insured. Some accounts offer debit card and check-writing privileges, providing instant access to your funds.
• Certificates of Deposit (CDs): CDs can offer higher interest rates, especially for longer maturities. However, early withdrawal usually incurs a penalty, making it challenging to access your funds immediately. Consider creating a CD ladder or exploring no-penalty CD options for improved liquidity.
• Bank or credit union account: These accounts are generally considered safe places to keep your money, and you can designate a specific account for your emergency funds.
• Prepaid card: You can load money onto a prepaid card, which is not connected to a bank or credit union. This option provides easy access to your funds, but be aware of any associated fees.
• Cash: Keeping cash on hand, either at home or with a trusted person, is another option. However, cash is susceptible to theft, loss, or destruction.

Strategies for Building Your Emergency Fund:

• Create a savings habit: Set a specific goal, establish a system for consistent contributions, regularly monitor your progress, and celebrate your successes.
• Manage your cash flow: Adjust the timing of your income and expenses to identify opportunities for saving. Work with creditors to modify due dates for bills and take advantage of weeks when you have extra money to boost your savings.
• Take advantage of one-time opportunities: Utilize tax refunds, holiday gifts, or other financial windfalls to quickly boost your emergency fund.
• Make your saving automatic: Set up recurring transfers from your checking account to your savings account. This ensures consistent contributions without requiring constant effort.
• Save through work: If you receive direct deposits from your employer, consider dividing your paycheck between your checking and savings accounts.

Why You Shouldn't Invest Your Emergency Fund:

While it may be tempting to invest your emergency fund to earn higher returns, it's generally not advisable due to the risk of losses and reduced accessibility. Here's why:

• Potential for investment losses: Investing in the stock market or other high-risk options exposes you to potential losses. If the value of your investments decreases, you could lose a significant portion of your emergency savings.
• Difficult access and penalties: Investments like retirement funds and certificates of deposit (CDs) may have restrictions and early withdrawal penalties, making it challenging to access your funds when needed.
• Tax consequences: Withdrawing from taxable brokerage accounts triggers tax payments, and emergencies may force you to sell assets within a year, resulting in higher short-term capital gains taxes.

Best Practices:

• Separate from spending money: Keep your emergency fund separate from your daily spending money to avoid the temptation of dipping into it for non-emergencies.
• Focus on liquidity and accessibility: Prioritize keeping your emergency funds in liquid accounts that you can easily access without penalties.
• Avoid risky investments: Steer clear of volatile investments like stocks for your emergency fund, as you may be forced to sell at a loss during an emergency.

Short-term goals

When it comes to short-term financial goals, it's important to have a focused and practical approach to setting and managing your goals. This will ensure that you achieve them and prevent you from borrowing money from other long-term goals. Setting SMART financial goals is a good strategy, where your goals are specific, measurable, achievable, relevant, and time-bound.

For instance, if you're saving for a large purchase, determine the cost of the item and save a fixed amount each month by cutting unnecessary expenses. You can also use a separate savings account to avoid spending the funds prematurely.

• High-yield savings accounts: These accounts offer competitive interest rates, with current annual percentage yields between 4% and 5%. They are FDIC-insured, protecting your money up to $250,000 per institution.
• Cash management accounts: These accounts are offered by robo-advisors and online investment firms, providing features such as check writing, mobile check deposit, and bill payment. They typically offer interest rates between 3% and 5%.
• Short-term bond funds: These funds offer a variable or fixed interest rate over a specified period. U.S. government bonds are considered the safest, and you can purchase them via an online brokerage account.
• Bank certificates of deposit (CDs): CDs offer a pre-set, guaranteed interest rate if you lock in your money for a set term, usually ranging from three months to five years. They are a good option for risk-free savings if you are sure you won't need the money during that period.
• Money market mutual funds: Unlike FDIC-insured money market accounts, these funds are a basket of investments that hold your money in high-quality, short-term debt instruments, cash, and cash equivalents. They are not insured by the FDIC.
• Robo-advisors: These are accounts where investments are chosen automatically for you based on an algorithm. You answer questions about your goals, time horizon, and risk tolerance, and the robo-advisor selects a mix of investments to help you achieve your goals.

Long-term goals

When investing for long-term goals, it is generally recommended to have a higher allocation of stocks in your portfolio. Historically, the stock market has trended higher over time, and individual stocks can be a powerful tool for long-term growth. Stocks offer the potential for steady growth in value, as well as growth through dividends.

Another investment option for long-term goals is exchange-traded funds (ETFs). ETFs are similar to mutual funds and are a basket of investment securities that track a particular index, sector, commodity, or other assets. They can be bought and sold on a stock exchange, just like individual stocks.

Additionally, it is important to consider your risk tolerance when investing for the long term. While investing in the stock market can provide the potential for higher returns, it also comes with higher risk. If you are uncomfortable with taking on more risk, you may want to consider less risky investments, such as bonds or cash management accounts.

When deciding between saving and investing for your long-term goals, it is crucial to prioritize determining when you will need the money. If you are planning for retirement or have a long time horizon, investing may be a better option to grow your wealth. However, if you are saving for a specific goal within the next two to three years, it may be better to keep your money in a savings account to avoid the risk of market fluctuations.

Overall, when investing for long-term goals, it is important to have a well-diversified portfolio that aligns with your financial objectives and risk tolerance. Seeking advice from a financial advisor or planner can also help you make informed decisions about your investments.

Risk tolerance

When deciding between saving and investing, it's important to consider your financial goals and time horizon. Saving is typically recommended for short-term goals, such as building an emergency fund or saving for a down payment on a house. It is also a good option for those who need quick access to their money, as there are minimal barriers to withdrawing funds from a savings account.

Investing, on the other hand, is generally recommended for long-term financial goals, such as retirement or saving for college. It offers the potential for higher returns than savings accounts, but it also comes with greater risk. Investing in the stock market, for example, can be volatile, and there is no guarantee that you will make money. It's important to remember that investing requires a long-term perspective, and it may take years to see significant returns.

To determine your risk tolerance, you should assess your financial goals, time horizon, and comfort level with potential losses. If you have a low risk tolerance, you may want to prioritize saving or invest in more conservative options, such as bonds or money market accounts. If you have a higher risk tolerance, you may be more comfortable investing in riskier assets, such as stocks or exchange-traded funds (ETFs). It's important to remember that risk tolerance can vary depending on your financial situation and goals, and it may change over time as your circumstances evolve.

Retirement plans

Defined Contribution Plans:

Defined contribution (DC) plans, including 401(k)s, have become the most common type of retirement plan offered by employers. In 2019, around 86% of Fortune 500 companies offered DC plans instead of traditional pensions. 401(k) plans allow employees to contribute pre-tax wages, which grow tax-free until withdrawal at retirement. There's also the option of a Roth 401(k), where contributions are made with after-tax dollars but can be withdrawn tax-free. Employers often match contributions, providing an incentive for employees to save. The contribution limit for 401(k) plans in 2024 is $23,000, or $30,500 for those aged 50 and over. Similar plans include 403(b) and 457(b) plans, offered to employees in the public sector and government.

Traditional Pensions:

Traditional pensions, or defined benefit plans, are fully funded by employers and provide a fixed monthly benefit to retirees. However, they are becoming less common, with only 14% of Fortune 500 companies offering them to new workers in 2019. Pensions offer the advantage of a guaranteed income for life, typically based on a percentage of the employee's pay and years of service. However, they may not be portable if an employee changes jobs, and there is a risk of the company being unable to fulfil its pension obligations.

Individual Retirement Accounts (IRAs):

IRAs are retirement plans created by the US government and are available to anyone. There are different types of IRAs, including traditional and Roth IRAs. Traditional IRAs offer tax advantages, as contributions are made with pre-tax dollars and grow tax-free until withdrawal. On the other hand, Roth IRAs are funded with after-tax money, and withdrawals in retirement are tax-free. There are income limits for contributing to a Roth IRA, and contribution limits for IRAs in 2024 are $7,000, or $8,000 for those aged 50 and over.

Employer-Sponsored Plans:

In addition to 401(k) plans, employers may offer other types of retirement plans such as pension plans, 403(b) plans, and 457(b) plans. These plans often include employer matching contributions and provide tax advantages. It's important to take advantage of these plans if offered, as they can help employees save effectively for retirement.

Self-Employed or Small Business Plans:

For those who are self-employed or own a small business, there are specific retirement plan options such as solo 401(k)s, SEP IRAs, SIMPLE IRAs, and profit-sharing plans. These plans offer higher contribution limits and the ability to profit-share. They also have less regulation and provide a wider range of investment options.

When planning for retirement, it's important to consider factors such as your age, income, expenses, and retirement goals. It's recommended to save at least 10% to 15% of your income annually, but this may vary depending on your personal circumstances. Seeking advice from a financial advisor can help you make informed decisions about your retirement plans.

Frequently asked questions