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With interest rates down and market volatility up, one of the more frequent questions that I get from clients is ‘What should I do with money that’s sitting in the bank which is making little, if any, interest?’ My answer will vary based on factors such as the amount of money in question, time horizon, risk tolerance, and if there are any outstanding debts, but here are the alternatives that I typically explore:
1) Leave it in the bank as an emergency fund. As a starting point, I like to see between three and six months of living expenses set aside in a separate bank account and earmarked to only be spent in case of a true emergency. Yes, it’s no fun to have your money not earning any interest, but it’s far more important to have cash available if you need to repair your vehicle, take a child to the doctor, or encounter any other sort of emergency. Your emergency fund should not be subject to any market risk or any withdrawal penalties. Like a lot of other things, it is far better to have an emergency fund in place and not need it than to need it and not have it!
2) Consider paying off your debts. After setting aside money for emergencies, take a look at any debts that you have. I don’t know how many times I’ve run into clients who have outstanding student loan debt that they keep paying on for the tax deduction or a vehicle loan that they took out because it was a ‘good deal’. There are few scenarios that you should be paying interest on a loan when you have the money in the bank to pay it off.
3) Utilize retirement accounts. This suggestion is a little more complex due to the fact that the amount and source of your income as well as your tax filing status impacts what types of retirement plans you qualify for. Generally speaking, you want to contribute to a work-based plan such as a 401k or the Thrift Savings Plan up to the amount where you get the full employer match. After getting the employer match, a Roth IRA or Roth 401k makes sense if you see your income taxes being higher in retirement; a Traditional IRA or 401k makes sense if you see your income taxes being lower in retirement. Again, there are some complexities surrounding these issues so seek professional guidance or check out IRS Publication 590 which gets into detail about all types of IRAs.
4) Set up escrow accounts for large, infrequent purchases. While I avoid taking a wrecking ball to how clients’ handle budgeting/cash flow/spending decisions if what they are doing is working, I do have some strong beliefs on how to optimize money management. Ideally what I like to see is a three tier system where a) all fixed payments such as utilities, housing, and debt payments are paid once a month; b) all variable expenses such as gas, groceries, dining, clothing, and entertainment have a set ‘allowance’ every week; and c) future large, infrequent purchases such as new vehicles, vacations, and a child’s education expenses have separate accounts set-up where the money can be escrowed for a period of months or years. While not essential like the first two tiers, having money set aside for big expenses keeps your overall financial plan from being knocked off course and is a wonderful tool if your household has irregular or commission-based income.
For most of us, the ultimate goal is to have our spending be less than our incomes and to put away the monthly surplus into things that grow in value, provide an income, or both. By having a good foundation of enough money in the bank for emergencies and other known short-term needs in place but not so much where the money becomes ‘lazy’ is a good first step to financial freedom and independence.