How Much Cash is Too Much?
I recently had a conversation with someone in their 20s about cash. Specifically, how much is too much?
I love this question, especially from someone who has multiple decades of potential compounding in front of them.
Before getting into a few details, when I talk about cash, I’m referring to money held in some type of interest-bearing account like checking accounts, savings accounts, and even money market funds. I’m not talking about the secret stash in the sock drawer. For the examples below, we use the 3-month U.S. Treasury Bill rate as our proxy for cash.
is cash trash?
Historically, cash has not been one of the best long-term investments, especially after we consider taxes and inflation, relative to other options that have protected or even grown purchasing power.
TAXES
The interest earned on cash is typically taxed as ordinary income. Ordinary income tax rates are usually the highest rates and individual or family will pay on their income. The current high end of the federal income tax bracket is 37%. States like Kansas and Missouri have tax rates that can be close to 5% or 6%.
Assume we can earn 5% in a savings account today, and we have $50,000 in that account. The interest from that account over the course of a year, assuming interest rates don’t change, would be $2,500. That’s the pre-tax return.
If that person pays a combined federal and state tax rate of 30%, they will owe $750 in income tax on that interest. They get to keep the other$1,750. And their after-tax return falls to just 3.5%.
INFLATION
The price we pay for goods and services usually rises over time. Consumers have become reacquainted with inflation over the past few years as post-COVID inflation rates in the U.S. hit levels not seen since the early 1980s.
The chart below shows the impact inflation has had on cash.
The green line shows how much a physical dollar bill has depreciated since the early 1980s. About 70% of the value is gone. If a dollar in 1981 could buy a cheeseburger, that same dollar today would get you just a couple bites.
Most people don’t hoard physical cash, though. The black line assumes someone invested their money and earned the rate on 3-month U.S. Treasury Bills each month. $1 invested T-Bills in 1981 would now be worth $4.91. That may not sound too bad, but that’s before taxes and inflation.
The orange line adjusts the T-Bill return for inflation. The difference is huge. Inflation consumed 88% of your return.
Now let’s add in those taxes we just mentioned. The brown line assumes the monthly interest earned on T-Bills is taxed at 30%. After accounting for taxes and inflation, we are left with just $0.91 from our original dollar. Yuck.
When people say cash is trash, this probably explains their perspective.
INTEREST RATES
Then there’s the issue of interest rates. A couple weeks ago, we talked about the difficulty in predicting where rates are headed.
The second chart shows how rates have changed since the early 1980s. We also included the average interest rate on those 3-month T-Bills for each decade. Someone who retired in 1981 could earn over 10% on their money by just investing in these T-Bills. By 1990, if they continued investing in these same bills, their income would have been cut by about half.
Today, it’s not too difficult to earn 5% or more on idle savings. Short-term interest rates haven’t been this high in over 15 years. I certainly don’t fault investors for being content with a 5% return, especially if it’s in a tax-advantaged account. We would just suggest weighing the pros and cons if those dollars aren’t going to be spent in the next decade or more.
is cash king?
Can cash and cash alternatives still make sense in the right circumstances? We think so.
EMERGENCY SAVINGS
Rainy days happen. We generally suggest people have 3-6 months of living expenses in an emergency fund, depending on whether the household has single or dual incomes. High yield savings account or money market funds can be good options. The goal here is stability and liquidity, not earning the highest returns.
SHORT-TERM GOALS
Planning to buy a house in the next few years? Maybe you need to buy a car for a teenager next year. You could be starting a business and need to support normal living expenses for a year or two. Cash can be a great place to save for short-term goals.
Prioritizing safety and liquidity over potentially earning higher returns makes a lot of sense if the money will be needed within the next few years. Since 1970, the S&P 500 has lost at least 35% in a 2-year period on three separate occasions. It hasn’t happened often, but using long-term investments like stocks to fund short-term goals can introduce unnecessary risks.
WHERE TO STASH YOUR CASH?
Last year, following the failure of Silicon Valley Bank, we shared some thoughts on how to keep cash safe while still earning decent interest rates. Here is a quick overview:
High yield savings accounts: these are FDIC insured up to a certain limit. A quick Google search can point you to banks and credit unions offering 5% or more on these accounts.
Cash management programs: may be appropriate for people with more cash than the FDIC limits protect in a single institution.
Money market mutual funds: these funds come in a few varieties. Some pay interest that’s taxable, while others invest in tax-free municipal securities. Both give investors access to their money within a day or two.
Treasury securities: backed by the full faith and credit of the United States Government, they can be purchased to meet most maturity needs, are considered very high quality, and are typically among the most liquid securities in the world.
Interested in talking more?
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