When you think about your financial future, you probably have two kinds of goals: short-term goals, like a vacation you plan to take later this year, and long-term goals, like sending a child to college or retiring. In order to give yourself the best chance of comfortably reaching those goals, you should approach your short-term savings and long-term savings differently. Here’s exactly what you need to know.

The 3–5 year rule

First, let’s talk about the difference between a short-term goal and a long-term goal. As a rule of thumb, we define a short-term goal as anything in the next three to five years. A long-term goal is anything more than three to five years away. If your goal is in the middle of that range, say four years, you should take into account how flexible your timing is. 

For example, if you know you will definitely want to buy a new home in four years and you have no flexibility on the timing, you may want to treat that as a short-term goal. But if you are pretty flexible and would be OK waiting another year or so if you needed to, it’s probably fine to treat buying that home as a long-term goal.

Save for short-term goals in a high-yield cash account

If you have a short-term goal, it’s important to make sure the money you’ll need is available when you’re ready to spend it. That’s why you should save for short-term goals in a low risk, high-yield cash account. By using a high-yield cash account (like the Wealthfront Cash Account) you can avoid taking market risk with your short-term savings and also earn many times the interest you’d otherwise earn at a traditional bank. You should choose an account that doesn’t charge fees, as fees will erode your wealth over time. You’ll also want to pick an account where your savings will be FDIC insured.

Avoid the temptation to invest your short-term savings. Financial markets are unpredictable in the short term, and it would be unfortunate to need cash at the exact moment your investment portfolio temporarily declined in value. This is the same reason that it typically makes sense to keep your emergency fund in a high-yield cash account instead of in the market.

Save for long-term goals in an investment account

If you’re saving for a purchase you won’t make within the next three to five years, that’s a long-term goal. To save for your long-term goals, you should invest. Many people are tempted to hold their long-term savings in cash, but the problem with saving for long-term goals in a savings or cash account (even a high-yield one) is that the interest rate on these accounts has seldom kept up with inflation over the last decade. This means over time your savings can actually lose buying power. Investing can help you avoid this problem by allowing you to earn a higher rate of return over the long term.

There are a lot of different ways you can invest your money, but we suggest that you invest in a diversified portfolio of low-cost index funds instead of investing your life’s savings in individual stocks (which is riskier and more likely to end in you losing money). You don’t have to take our word for it: academic research has consistently found that diversifying your portfolio across asset classes is the best way to maximize returns across every level of risk. 

When choosing an investment account, there are two main types to consider: tax-advantaged (meaning they come with tax breaks) and taxable. 529 accounts and IRAs are examples of tax-advantaged accounts you can use to save for specific goals like sending a child to college or retirement, respectively. However, it’s important to understand that these accounts come with withdrawal restrictions and penalties if you don’t use them according to the rules governing each specific account type. Taxable accounts, on the other hand, are highly flexible. You can use them for whatever you want, and you won’t pay a withdrawal penalty for taking your money out. Plus, if you use a taxable account, you can conduct tax-loss harvesting—a strategy that takes advantage of market volatility to lower your tax bill. How much can this help? In 2021, Wealthfront’s automated Tax-Loss Harvesting service generated average estimated tax savings worth between 4-9x our annual 0.25% advisory fee for clients who started using the service in a Classic or Socially Responsible portfolio last year. 

In short, using a taxable investment account to save for a long-term goal means your savings have a better chance of increasing in buying power and growing significantly—and you’ll also have plenty of flexibility. Typically, the longer you stay invested, the better the odds that you’ll earn returns.

Key takeaways 

There’s an easy way to think about saving for your goals: risk and return are correlated. The higher the risk, the higher the expected return. This means in situations where you can’t afford to take any market risk (like when you’re saving for a short-term goal), you’ll sacrifice higher returns. But when you have a longer time horizon, your willingness to take on market risk can result in higher returns down the road—especially once you factor in the impact of compounding

Here’s what you need to remember:

  • Keep your short-term savings in a high-yield savings account with low fees, FDIC insurance, and a high APY. That way, your money will grow a little and be there when you need it.
  • Keep your long-term savings in a low-fee, diversified investment account. That way, your money will have a better shot at keeping up with inflation and increasing your buying power.

No matter what kind of goal you’re saving for, Wealthfront offers the accounts you need to meet them with confidence. For your short-term savings, our Cash Account comes with a high interest rate, absolutely no account fees, and $3 million of FDIC insurance through our partner banks (which is 12x what you’d get from a traditional bank). For your long-term savings, we offer taxable and tax-advantaged Automated Investing Accounts with a full suite of automation features designed to maximize your after-tax returns and make investing effortless. 

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Cash Account is offered by Wealthfront Brokerage LLC (“Wealthfront Brokerage”), a Member of FINRA/SIPC. Neither Wealthfront Brokerage nor any of its affiliates are a bank, and Cash Account is not a checking or savings account. We convey funds to partner banks who accept and maintain deposits, provide the interest rate, and provide FDIC insurance. Investment management and advisory services–which are not FDIC insured–are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and financial planning tools are provided by Wealthfront Software LLC (“Wealthfront”).

The cash balance in the Cash Account is swept to one or more banks (the “program banks”) where it earns a variable rate of interest and is eligible for FDIC insurance.  FDIC insurance is not provided until the funds arrive at the program banks. FDIC insurance coverage is limited to $250,000 per qualified customer account per banking institution. Wealthfront uses more than one program bank to ensure FDIC coverage of up to $3 million for your cash deposits.  For more information on FDIC insurance coverage, please visit www.FDIC.gov. Customers are responsible for monitoring their total assets at each of the program banks to determine the extent of available FDIC insurance coverage in accordance with FDIC rules. The deposits at program banks are not covered by SIPC. 

The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront Advisers and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term).

Wealthfront Advisers’ investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.

Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.

Nothing in this communication should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront Advisers or its affiliates endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.

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About the author(s)

Joanna is a Senior Product Specialist at Wealthfront. She is a licensed financial advisor in the U.S. and Australia, holding Series 7 and Series 66 licenses from FINRA. Before joining Wealthfront, Joanna worked at Dimensional Fund Advisors.