One of the most common questions I receive from my clients is: “What should I do with my cash?”
There are essentially three options: Spend it, save it, or invest it.
The answer may be simpler than it appears. I generally recommend that my clients work through these four questions. Spending, saving, and investing are all correct answers — it just depends on where you are in your financial journey.
1. Do you have a sufficient emergency fund?
Your emergency fund should contain enough cash to fund your household’s existing expenses for three to six months. If you lost your job or some of your income, your emergency fund would sustain you and your family until you found a replacement source of income.
How much you need in your emergency fund varies widely. I have some clients who only keep three months of cash on hand because they have highly desirable skill sets and would likely be able to find a new job quickly. Others have multiple streams of income, so the loss of one job would result in just a small reduction in income. There is no right or wrong answer — it merely depends on how comfortable you are with risk.
If you aren’t sure how much cash would be required for three to six months of expenses, take a step back and learn how to understand your cash flow.
If you own your own business, you should have a separate emergency fund for the business so you aren’t funding the business with your personal savings and income. This way, when the business faces a crisis, you won’t face personal financial hardship too.
2. Are you funding your short-term and long-term spending goals?
Think about expenses you will face in the near future as well as the distant future. Are you saving for international travel, a kitchen renovation, or a down payment on your next home? What about education savings for your children?
Discuss these goals — and how much each will cost — with your partner or spouse. Then talk about how you’d like to save for them.
For travel, you may be comfortable using a credit card and paying it off quickly or funding your annual travel budget monthly in a separate account. For a down payment on a home, you may decide to open a high-interest savings account. For kids’ education, you will likely start or increase your allocations to a 529 or another type of college savings fund.
Once you’ve outlined your goals, allocate some of your extra cash to them. You may be closer to achieving them than you realized!
3. Are you fully funding your retirement accounts?
Once your emergency fund is fully funded and you are putting money away for your goals, you have the ability to redirect any excess savings to investments.
Before moving into other asset classes, note whether or not you are fully funding your retirement. If not, consider fully funding your 401(k), IRA, 403(b), or other retirement accounts, or at least investing enough to get any match your employer offers.
If you own your own business, set up a retirement plan for yourself. If you are below the income limits or able to do a backdoor Roth IRA, consider funding this once you’ve maxed out on employer retirement accounts.
4. Where do you want to invest?
When considering how to allocate your investment dollars, think carefully about how much risk you’re comfortable with and how liquid you want your assets to be.
If you prefer to be able to access your money quickly, consider setting up a taxable investment account, which is invested in financial markets. In a worst-case scenario, the money you’ve invested would be relatively easy to access: You pay tax on any gains in the portfolio that you liquidate out of, but as long as you’ve held the investment for longer than one year, it will be taxed at the long-term capital gains rate.
Yes, you will have to pay taxes on the returns annually. But compare this to a retirement account: When you pull funds from retirement, they are subject to income tax, plus a 10% penalty if you are younger than 59 and a half.
The majority of financial advisors will recommend investing your taxable money in a diversified portfolio, so that if any one company in your portfolio suffers, you won’t acutely feel the impact. (Recent Money Checkup guest Chloé A. Moore, CFP, recommends tying no more than 5% of your portfolio to a single stock.)
But if you have an itch for stock-picking, allow yourself to set aside a small pot of money as “play money.” There are online trading platforms that allow you to purchase fractional shares of highly valued companies.
Many of my clients are interested in investing in real estate. Owning real estate assets, in full or as part of an investing group, can generate reliable passive income from tenants — but like all asset classes, it also comes with risk.
Private equity deals offer an opportunity to invest in real estate without having to identify properties or manage tenants yourself. Your financial advisor can help you vet these deals to make sure the sponsorship team has a trustworthy track record.
Active real estate investing involves building your own portfolio of properties, from purchasing to renovating to securing tenants. Some investors love this process and quickly grow portfolios. (If you spend enough time on your real estate investing business, you may qualify for real estate professional status, which can be helpful in tax planning.) Others buy one property at a time to develop a secondary income stream.
Talk to your financial advisor about how to get started in the real estate investment space. They may be able to connect you to resources or other people who can help.
Can’t I just keep my cash in my bank account?
I think having liquid cash in an emergency fund and for your upcoming expenses is important. However, I simply don’t recommend keeping more than that in cash. Cash does not earn anything, especially in our current low-interest-rate environment. Because of inflation, cash actually loses value when it sits for too long.
Investing your money gives you the benefit of time value of money. When invested, your money compounds and grows. Even if it doesn’t grow in a perfectly straight line, the stock market has consistently gone up over time.
That said, view your extra cash with prudence and diligence, and put thought into what you want to do with it. Treat your extra cash as a burst of speed toward your goals: Which do you want to reach the fastest?
