When you think about your financial future, you probably have three kinds of goals: short-term goals, like a vacation you plan to take later this year, near-term goals, like a down payment for a house, 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, near-term, and long-term savings differently. Here’s exactly what you need to know.
The 1–3 and 3–5 year rule
First, let’s talk about the difference between the three types of goals. As a rule of thumb, we define a short-term goal as anything in the next year, a near-term goal as something in the next one to three years, and 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 near-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, within the next year, it’s important to make sure the money you’ll need is available when you’re ready to invest or spend it. That’s why you should save for short-term goals in a 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 cash 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.
Invest for near-term goals in a diversified portfolio of bonds or bond ETFs
If you’re planning for a big expense one to three years from now, we consider that a near-term goal. To save for your near-term goals, you have a few different options. One is to hold your savings in your high yield savings or cash account for a longer period of time. If you’re in the market to buy a home and waiting for the perfect opportunity to come along, you might prefer to hold those savings in cash so that you can jump at the opportunity sooner than you expect. If you’re open to taking on some risk and you know the opportunity is going to be at least a year from now, a good optimization option for your savings is to invest in a fixed income product like Bonds or a certificate of deposit (CD). Bonds and CDs are lower risk than equities but have a higher potential earning than saving your money in cash.
It can be tempting to put all of your extra cash in just one or two bonds but like investing in equities, the best way to mitigate risk is to diversify across multiple bonds or bond ETFs.
There are many ways to invest in bonds: investors can purchase a bond directly through a brokerage firm or TreasuryDirect, or by investing in bond ETFs or mutual funds. Unfortunately, buying bonds directly can come with challenges: high minimums, lack of diversification, and liquidity restrictions. CDs come with similar liquidity challenges including set maturity dates and early withdrawal penalties. They also lock you in at a set rate that does not increase as interest rates rise leaving you at risk for earning less over the entire lockup period.
Bond ETFs avoid all of these obstacles because like a stock ETF, these are traded on stock exchanges throughout the trading day and hold a basket of bonds allowing it to remain liquid. This means the money is available to you regardless of a single bond’s maturity date and they are naturally more diversified than an individual bond.
Our Automated Bond Portfolio is made of a diversified mix of bond ETFs to provide a higher yield than Treasury bills, CDs, and high-yield savings accounts. They provide more liquidity than I bonds and CDs, less risk than equities and corporate bonds, and are tax optimized for your personal situation. This combination makes it a great place to grow the savings that you need soon but not urgently (those you hold in cash).
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, a good option is to invest in equities. 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) or even in bonds is that the rate of earning 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 in equities can help you avoid this problem by allowing you to earn a higher rate of return over the long term with a little added risk.
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 2022, Wealthfront’s automated Tax-Loss Harvesting service generated average estimated tax savings worth 15x 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.
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 near-term savings in a higher-yield, low-risk diversified bond portfolio. That way, your money will grow at a 1-3% higher rate than a high yield cash account with only a minor increase in risk helping you achieve your goals.
- 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, like your emergency fund or what you’re intending to invest in the future, you’re intending to invest, our Cash Account comes with a 5.00% APY through partner banks, no account fees, and up to $8 million of FDIC insurance through our partner banks (which is 32 what you’d get from a traditional bank). For your near-term savings, we offer our Automated Bond Portfolio, a diversified portfolio of Bond ETFs that we build and optimize to your personal tax situation. For your long-term savings, we offer taxable and tax-advantaged Automated Investing Accounts with diversified portfolios of low cost index funds, personalized to your risk tolerance and goals. The Automated Bond Portfolio and Automated Investing Accounts come with a full suite of our award-winning automation features designed to maximize your after-tax returns and make investing effortless.
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 $8 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.
“Investors should carefully assess the risks associated with bond ETF investments. Bond ETF performance may not precisely mirror the underlying index due to tracking errors from factors like bond weighting differences, transaction costs, and timing. Management fees can affect overall returns. Bond ETFs expose investors to risks, including interest rate risk, potentially leading to capital losses as rising rates decrease underlying bond values. Most bond ETFs lack a fixed maturity date or guaranteed principal repayment at maturity. Bond ETFs may generate capital gains from portfolio rebalancing, potentially resulting in unexpected tax liabilities.
Credit risk is a concern, as bond issuers’ financial health can impact ETF value. Some bond ETFs may use derivatives, introducing counterparty risk where losses can occur if a counterparty fails to fulfill its contractual obligations. Call risk should also be considered, as falling interest rates might prompt callable bond issuers to repay securities before maturity, forcing reinvestment in lower-yield or riskier securities.
Savings accounts are typically FDIC-insured. The Automated Bond Portfolio is covered by SIPC, which protects securities customers of its members up to $500,000 (including $250,000 for claims for cash). Explanatory brochure available upon request or at www.sipc.org . It does not provide protection against losses resulting from market fluctuations.
Bond ETFs are less liquid than cash, potentially affecting buying and selling shares at desired prices. Some may prefer the stability and accessibility of savings or deposit accounts despite lower yields.
Equities may offer higher long-term gains than bonds or cash investments, providing capital appreciation and reinvestable dividend income. However, equities present increased risk due to market fluctuations and short-term price volatility. Investors with longer time horizons and higher risk tolerance may allocate a portion of their portfolios to equities, acknowledging the possibility of gains and losses. Investors should weigh these risks before investing. Past performance does not guarantee future results.”
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 Product Specialist Manager 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. View all posts by Joanna Lawson