You may want to think twice before taking the old saying cash is king too literally. In the low interest rate environment of the last decade, holding cash will yield a real negative return (after inflation and taxes). Yet there are circumstances where it is advisable to stay liquid. Here are a few ways to tell if you're holding too much cash and some ways you can put your hard-earned cash to work for you.
Do I have too much in cash?
Whether you have recently experienced a liquidity event from a windfall or have just saved diligently over the years, holding too much cash is one of the top five biggest risks facing investors today. Since every investor will have varying liquidity needs and cash balance comfort levels, perhaps the best way to determine whether you are carrying too much cash is to first estimate a minimum cash balance. If you are holding too much cash, consider working with a wealth management professional to develop an investment management strategy consistent with your goals.
Emergency Fund Reserves
Emergency funds should be kept in cash and fully liquid. Investing an emergency fund in the stock market carries a risk of loss due to market downturns. Certificates of deposit (CDs) are generally not a good way to keep emergency cash either, as the funds cannot be accessed until the maturity date.
In general, unmarried investors should have roughly six months of non-discretionary living expenses in cash emergency reserves. Non-discretionary living expenses include food, housing, insurance, and so on, essentially the minimum monthly amount you would need to survive and get back on your feet. Married investors in a dual-income household should have at least three months of non-discretionary living expenses in cash.
Households with children should have more saved up, particularly if there is only one working spouse or one parent with access to benefits like health insurance. Always adjust these basic guidelines to fit your situation as many factors will impact your required reserves.
Upcoming Major Purchases
A separate consideration from emergency reserves is whether you have a major purchase, such as a
down payment on a home, on the horizon. Generally, if you are saving to reach a goal within the next five years, consider keeping your reserves in cash. While the stock market can be expected to go up and down over the long run, investors have a much longer time horizon to recover from a downturn. Short term goals will have a much greater sensitivity to the market.
Invest extra cash or pay down debt?
If you have more cash on hand than you believe you'll need, make it work for you. Don't wait until your reserves have swelled tens of thousands past your needs - systematically investing your monthly excess cash flows can pay off big over time.
Pay down debt
Paying down debt feels good, but it isn't always the best use of surplus cash. For one, you cannot access the funds later. Also, depending on what type of debt you have and the interest rate, your dollars could earn a higher rate of return invested in the market than you'd get in saved interest expense.
Typically, it is not advantageous to pay off a mortgage early. Most Americans have refinanced high interest rates into lower fixed rates over the past few years. Further, the mortgage interest tax deduction could provide a meaningful benefit for taxpayers who are able to itemize their deductions.
If you are holding consumer debt or have high interest student loans, weigh your options more carefully. If you determine that it is advantageous to pay down debt instead of investing your excess cash, consider substantially increasing your monthly payment instead of making a lump sum payment. This can drastically reduce your lifetime interest expense but still provide the flexibility of using the cash for other purposes "in case."
Ways to invest extra money
Save in a retirement account
Depending on your situation, you may be able to make a tax-deductible contribution to a traditional IRA or contribute to a Roth IRA. Check the 2019 IRS limits.
Even if you don't qualify for a Roth or tax-deductible additions to a traditional IRA, you may still make non-deductible contributions to a traditional IRA, subject to the annual limits. Both of these types of retirement accounts can offer tax-deferred growth and an incentive for investors to save for their future. In 2019, the maximum annual contribution to an IRA is $6,000 (regardless of whether it was tax-deductible), so if you have a lot of extra cash saved up, you may wish to consider investing in a brokerage account.
Save in a brokerage account
While IRAs may offer tax benefits and deferred growth, there are restrictions on when the funds can be withdrawn, when they must be withdrawn, and there are penalties for tapping the account early. A non-retirement brokerage account offers the most flexibility and is a great way for investors to diversify their assets between tax deferred, tax-free, and taxable accounts.
Brokerage accounts can be funded with any amount and offer a wide variety of options to suit your investment management strategy. Taxable brokerage accounts offer many investors the most flexibility for their excess cash - it can be withdrawn at any time, for any purpose, and can work a lot harder for you over the long-term compared to cash.