Money

Getting Higher Returns on Your Cash

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I started blogging about personal finance in 2014. In the ensuing decade I’ve written about cash savings in depth exactly zero times. 

Interest rates started low and got lower for nearly a decade. There wasn’t much to write about.

After the spike in interest rates over the past few years and more recent talks about potential rate cuts, cash has become a topic of interest. In just the past few weeks I’ve received questions from blog readers, family, and clients on the following topics:

  • The best place to hold cash reserves,
  • How much cash vs. other short-term reserves to hold heading into retirement,
  • The tax efficiency of money market accounts vs. savings accounts, and
  • How to lock in current rates with interest rates scheduled to be cut.

In my own personal finances, I recently encountered a situation that caused me to reassess when the effort to move my cash to get higher returns on cash is justified. It’s time to cover this topic that I’ve managed to avoid for so long. So let’s jump in….

Why Hold Cash?

Let’s start with a couple foundational questions which will help answer all of the others. There are two main objectives to having cash holdings.

The primary purpose of cash is to provide liquidity. Cash should be held where you can access it when you need it quickly and without having to sell anything at depressed prices. Having adequate liquidity is a key component of your financial health.

The secondary objective for savings is to earn a return on your cash until you need it. This is a part of your portfolio you don’t want to subject to much, if any, risk. A realistic goal for cash holdings is to keep pace with inflation over time. Until you do need these savings, you want these dollars to maintain their purchasing power. 

This isn’t always possible with risk free assets. Alternatively, there are periods when you may do a bit better than inflation. 

Anything that proposes to do much better than this over long periods of time should be viewed with suspicion. Risk and return tend to go hand in hand.

How Much Cash Should I Have?

The amount of cash you hold depends on your personal circumstances. A guideline of 3-6 months of expenses in an emergency fund is standard advice. 

This is a reasonable goal for most people in their accumulation phase. However, as I’ve written about in the past, this target is deceptively hard to reach, especially for those who would benefit most from achieving it. Conversely, those with stable jobs and high savings rates may not need to hold much, if any, cash. 

In my household, Kim and I created a lifestyle that could be supported on one of our incomes. We used the other to pay off debt, invest, and spend on rare splurges. My career was very secure. So we never held any cash throughout our accumulation phase other than a few thousand dollars in a checking account to meet normal spending needs.

At the other extreme, holding far more than 3-6 months of expenses may be prudent. Some people are preparing to buy a house and want to have a large down payment or buy the home outright. Many retirees prefer to hold at least a year of expenses in cash.

You may be nearing or in retirement and simultaneously be looking to buy a home or make other large purchases. Holding a high six figure sum in cash may make perfect sense in this case.

Does It Make Sense to Pursue Higher Interest Rates on Cash?

Most of us fall somewhere between these extremes. There are a few factors that dictate whether it makes sense to try to optimize returns on cash and how to go about doing so. 

There is one scenario where it almost always makes sense. Let’s start there.

Asleep at the Wheel

Interest rates have risen dramatically since bottoming out at the end of 2021. Many consumers have benefitted with higher rates on money markets, treasuries, and savings accounts. But a surprising number of people are not benefitting. Don’t be one of them!

In the past year, I’ve had my dad and multiple clients move money from savings and money market accounts to different higher yielding savings or money market accounts. They increased the yield on their cash by about 4% on average. More importantly, this was possible without increasing risk.

As noted above, this dramatic increase in return without a simultaneous increase in risk should generally raise suspicion. In this case, it was just an example of some institutions taking advantage of people who are not paying attention to the dramatic shift in interest rates.

Sub-Par Rates Persist

This situation persists. As recently as a few weeks ago I encountered this situation with my HSA with Lively. I chose Lively years ago because they were the only HSA provider at the time that allowed first dollar investing through TD Ameritrade. This changed after Schwab acquired TD.

I now am required to keep $3,000 in cash savings or pay a $24 annual fee for the privilege of investing my entire HSA account. I found this change annoying, but I now keep some of my HSA in safer assets anyway. So I didn’t think this would be a big deal. Then I checked the rates they are paying on cash savings (See screenshot below).

I found this appalling. My FDIC insured high yield savings account at Ally bank is paying 4.35% with no minimum balance.

I encourage everyone with any substantial amount of cash in savings to check to make sure you are getting a competitive yield on your cash in a high yield savings account or money market. Don’t overlook cash accounts at otherwise highly recommended brokerages. Schwab, for example, makes over half of their revenue from interest on deposits, loans, and securities.

Worth the Effort to Optimize?

Moving your cash to an institution that pays competitive rates without sacrificing safety and convenience is a no brainer. The spreads are large, so not doing so results in leaving free money on the table. Institutions that are paying essentially no interest on savings in this environment make me doubt whether they have consumers’ best interests in mind.

Beyond picking this low hanging fruit, the benefit of optimizing returns on your cash comes down to a few factors.

  1. The amount of cash you hold. The benefit of getting an extra .5% interest on a $10,000 emergency fund is negligible ($50/year). The same extra .5% for someone with a half million dollars in cash is substantial ($2,500/year).
  2. Your tax situation. Some options for cash holdings can be more tax friendly.
  3. The amount of effort you are willing to apply (or conversely convenience you are willing to sacrifice) to squeeze out this extra yield.

Best Options For Holding Cash

Keeping in mind that the first consideration for our cash holding is liquidity, there are three reasonable options for holding at least a portion of your cash:

  • High Yield Savings Accounts
  • Money Market Accounts
  • Money Market Funds

For those with larger cash savings that are earmarked for a certain time period, CDs and T-Bills may make sense. The convenience and typically higher yields of short-term bond funds make them attractive to some. I’ll also share why we personally are using I Bonds to hold a large amount of our cash allocation.

Savings Accounts

Savings accounts provide safety and liquidity. You deposit your money and can withdraw it as needed.

FDIC insured banks make these accounts virtually risk free up to $250,000 per owner per account type per institution (or $500,000 for a joint account). For those with larger cash holdings, it is wise to spread your money across multiple banks to take advantage of this protection as we witnessed last year when several banks failed.

Interest rates on savings accounts can vary considerably. They tend to be relatively low at local brick and mortar banks. Significantly better terms can be found at online banks.

A quick search of two local banks in my area (Utah) reveal that one, Zions Bank, offers variable rates of .16% for balances less than $1,000 up to a maximum of only .19% for accounts over $100,000. Bank of Utah offers significantly better terms, .6% for balances less than $10,000 up to a maximum rate of 2.07% for balances over $200,000.

In contrast, leading online banks including Ally, American Express, and Capital One all at the time of this writing offer 4.35% interest with no fees and no minimums. CIT Bank is offering 5.05% for balances greater than $5,000. These FDIC insured banks are all established and have a reputation of offering consistently competitive rates.

Beware of savings accounts with higher introductory offers or sign up bonuses. These offers can be accompanied by a bait and switch to much lower rates. This creates a mental burden to keep track of rates and hassle to move accounts.

Money Market Accounts

Money market accounts, like savings accounts, are covered by FDIC insurance. Banks invest the funds in high quality, short-term investments. These features provide safety and liquidity.

A feature that traditionally was attractive about money market accounts was the ability to write checks from these accounts. As our world is becoming more digital, this is likely not a difference maker for most of us.

Interest rates may be higher than what you can get with traditional savings accounts at brick and mortar banks, but will likely be lower than what you will get with online savings accounts. Thus, they may provide a middle ground for those who prefer to bank locally but are looking for higher interest rates.

Money Market Funds

Money market funds are mutual funds that typically invest in high quality, short-term debt instruments. Thus they tend to provide the liquidity we desire for cash holdings combined with competitive yields.

Interest rates on money market accounts are adjusted daily, making them less stable than interest rates on savings accounts which tend to move more slowly. This can work for or against you at different times as rates move up or down. The price of the shares of a money market fund are generally very stable at $1.

Money market funds are not covered by FDIC insurance. They do have SIPC protection.

The safest money market funds, like Vanguard’s Treasury Money Market Fund, as of this writing yield approximately 1% more than high yield savings accounts. Because these funds invest almost exclusively in US treasuries, they also are exempt from state taxation. This could make them an attractive place to store cash for those subject to state income tax.

There are state specific municipal money market funds, which can be exempt from federal and state income tax. This may make them attractive to some. However, this adds an increased element of risk that you may not want to take with your cash holdings.

CDs and T-Bills

With talk of interest rate cuts on the horizon, I’ve received multiple questions about ways to lock in current interest rates. I advise caution in making any financial moves based on predicting the future, which is inherently difficult.

Interest rate cuts, however likely, are not guaranteed to happen. If they do, we don’t know exactly when or how far rates will fall.

That said, it’s not unreasonable to put some of your cash into CDs or individual Treasury bills that will guarantee you a rate of interest until they mature. CDs are backed by FDIC insurance. Treasury bills are considered risk free assets, backed by the full faith and credit of the U.S. government.

Either of these may be desirable if you have a specific purpose for your money and are confident you know when you will need it. Examples are knowing you want to purchase a home in 18 months after your child will finish school or having cash earmarked for next year’s retirement living expenses. 

However, while you get the benefit of locking in your return for a set period of time, these benefits come with trade-offs.

You have to be confident you know when you will need your cash. If you need it before a CD matures, you may owe a penalty. If you need it before a T-Bill matures, you are subject to interest rate risk. Thus you don’t have the liquidity typically desired for cash reserves.

Locking in current rates is a double edged sword. You protect yourself if rates fall. However, you could miss out on higher rates if your prediction was wrong and rates go up or short term rates remain higher than longer term rates.

Bond Funds

An alternative to individual bonds are high quality short-term bond funds, such as Vanguard’s Short-Term Treasury ETF (VGSH). They generally will provide a higher yield than other cash savings (though that is not the case as of this writing) while investing in the safest bonds.

However, having any bond fund introduces some volatility. You don’t know exactly how much your shares will be worth until you sell them. For example, VGSH has a duration of 1.9 years. This means that if interest rates rise by one percent, your bond values will drop by approximately 2%. This may be more risk than you would like to incur for cash like holdings.

Related: How Low Can Your Bond Values Go?

A middle ground between buying individual bonds and bond funds are iShares iBonds ETFs. These ETFs enable buying US treasuries or TIPS that all mature in the same year. This provides the convenience of a bond fund with the price predictability of an individual bond at maturity.

These ETFs are compelling for building longer bond ladders. For cash reserves, one or maybe two treasury ETFs doesn’t seem much easier than buying a few T-bills. The expense ratio also adds cost that detracts from your return.

IBonds’ TIPS ETFs do provide a unique opportunity to easily buy TIPS that mature all in the same year. New TIPS are only issued with 5, 10, or 30 year terms. These funds have drawn a lot of attention in personal finance circles. 

Again, I think these funds are interesting for building longer bond ladders where the compound effect of inflation can significantly erode purchasing power over time. For shorter time periods for which I hold cash, inflation is less of a concern.

I Bonds

I’ll propose a final option for cash reserves that I haven’t heard many people talk about, but where we are currently keeping the lion’s share of our cash savings: I Bonds. It may be an attractive option for other readers in similar situations.

I started buying I Bonds after researching and writing about them in 2021. Since then, I’ve bought the allowable allotment of $10,000 each for Kim and I each year as rates have gone up.

An I Bond purchased through April 2024 has a fixed rate of 1.3%. Combined with the inflation adjustment, that bond has a total yield of 5.27% annualized for the next 6 months. That’s nearly 1% better than high yield savings accounts and similar to money markets. Even our old I bonds with 0% fixed rates are yielding 3.94% due to the inflation adjustment which is competitive.

There are clear drawbacks to I Bonds. The annual purchase limit means it takes time to build a sizable balance. And once you need the cash, you can’t replenish it like you would other cash holdings. But the annual purchase limit can provide a forced way to gradually build up cash savings in the years leading up to retirement.

Your money is locked up for one year after purchasing the bond. After that, your money is accessible at a known value (i.e. these bonds are liquid). 

In our case, we need significant cash reserves. However, we aren’t sure when we will need the cash. We drive a 10 year old vehicle, live in a 60 year old house, and have high-deductible health insurance. Kim’s income is tenuous. My blog income is tenuous and unpredictable. 

Now that we are purchasing our health insurance through the exchange, we don’t like to have any unnecessary taxable income. Limiting taxable income enables us to optimize our ACA premium subsidies. 

I Bonds allow us to defer taxes on interest income until we redeem the bond. So each year, we’re shifting money from our savings into I Bonds until we need the cash.

What Are You Doing With Your Cash?

I’m curious to hear what you are doing with your cash savings. Are you willing to take more risk or apply more effort than the strategies I’ve outlined? Do you have any creative strategies like my use of I Bonds that you use as an alternative to traditional cash reserves?

Let’s talk about it in the comments below.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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