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How to optimize your savings accounts

Most people know that they should have some savings set aside for "a rainy day". But how much exactly? What's the definition of "a rainy day"? What kind of account should they use? By optimizing these details, you can squeeze the last bit of earnings out of your liquid savings -- without spending more time than it's worth.

What are savings accounts, and what should they be used for?

Let's start, as any good analysis should, by defining terms. By "savings accounts", I mean in particular an account outside of your daily checking account set aside for a particular goal. The focus of this article will be on accounts for your next car, for your next vacation, for emergencies, etc. While I won't be talking about saving for retirement and for education -- those have additional variables and options that make them worth their own, separate analysis -- many of the fundamental concepts still apply.

Let's start with a couple items in this definition worth discussing in a little more depth: "outside of your daily checking account", and "for a particular goal".

When should you just use your checking account?

You don't need to establish a savings account for each expense that isn't paid for on a monthly basis. For instance, you might be responsible for annual registration and inspection of your car, but if you're using a good zero-based budget, you can likely take care of this directly from your normal cash flow. So when do you establish a savings account? When it exceeds your don't-care threshold. (We try to use technical terms here, whenever possible.) To calculate your d/c threshold, consider how much money per month would make it worthwhile for you to go through the trouble of establishing a savings account for a particular expense. $10? $20? $50? Now multiply by 12 and divide by the annual interest rate you estimate you'll get over and above what your checking account is earning. For example, say earning an extra $20/month would make it worthwhile, you'll be parking your cash in an account making 1.5%, and you have a money market checking account earning 0.25%. You'd have to have an average of $19,200 in savings to hit your d/c threshold; anything under that, and you shouldn't bother. Note that I say average; if you're setting aside money for that expense each month, your average in savings will be much lower than if you fund the savings account immediately.

Exception: you need some budgeting help. If you find yourself regularly carrying a credit card balance, establishing small, targeted savings accounts can be a helpful way of budgeting for irregular expenses, even if they're below your theoretical d/c threshold. In particular, Capital One 360 allows you to open multiple targeted savings accounts and set up automated transfers in just a few clicks. (No, I have no relationship with them; they've just always been very good at this particular aspect of saving.)

Why save for a particular goal?

In the definition I outlined earlier, I said that savings accounts should be for a particular goal. A lot of people who spend less than they make just put money away, without any particular purpose in mind. I strongly recommend that every dollar you possess should have a purpose. That's the idea behind zero-based budgeting: by "giving every dollar a job", you ensure that your spending is in line with (a) reality, and (b) your priorities. This extends to savings as well. True, no one knows what the future brings, but you can make some good guesses -- and by doing so, you put yourself in a much better position to handle the future when it comes.

Let's talk about emergency savings in particular. This can trip people up, because if you get fuzzy with the definition of "emergency", you can wind up raiding it for non-emergencies and then caught unprepared when a true emergency comes along. The best-practice definition of "emergency" includes any expense that (a) can't be handled in your normal cash flow, and (b) will severely impact your quality of life. This includes:

* Large, required auto repair expenses

* Large, required home repair expenses

* Large, required medical expenses

* Job loss of 3-6 months

Now, you could establish an emergency savings account that covers all of these, but best practice also states that holding enough in savings to cover all of these may not be worth the opportunity cost. Instead, the recommendation is generally to save for the largest -- almost always job loss of 3-6 months -- and use the account to cover the other listed emergencies, as well.

What kind of account should you use?

You've got an idea of what accounts you'd like to set up, and how much should go into each account. Now: how do you invest that money?

Online savings accounts are an excellent baseline. I highly recommend online savings accounts with an FDIC-insured bank such as Ally, Capital One 360, American Express, Discover, or Goldman Sachs' "Marcus". (I have no relationship with any of these, though I've used most of them at one time or another.) The account opening process is relatively straightforward, the interest rates on these accounts are all very competitive, and money can easily be transferred to or from these accounts from your normal checking account, with a 2-3 business day delay. Since they're FDIC-insured, the risk is lower than if you stuffed cash under a mattress, and the returns are much higher.

CD's are a potential optimization. You can also invest in an FDIC-insured CD with a term that matches the time when you'll need the money; because you don't necessarily need the money now, you can exchange access to that money for an additional "liquidity premium" on top of your normal returns. For example, if you're going on a vacation in a year, you could purchase a one-year CD. However, I recommend establishing a d/c threshold here, as well. As of March 2018, competitive online savings accounts are earning 1.5%, and a competitive one-year CD is earning 2.05%. Opening CD's takes a bit of work, and they're not nearly as flexible as a savings account. Let's say that you're OK with that if the liquidity premium is at least an extra $20/month over just using a savings account; this means you'd need an average balance of $43,636 to make it worthwhile. (I don't know about you, but my vacations aren't that expensive.)

You could theoretically invest in a bond, but one-year US Treasury bonds are yielding 2.03% as of March 2018, so you may as well stick with one-year CD's in most cases. You can trade risk for returns by investing in corporate bonds, but that's beyond the scope of this post; almost always, the additional risk isn't worth the potential returns.

What about emergency savings?

Emergency savings have an interesting wrinkle: you don't need the money now, necessarily, and you might never need it at all -- but you could any day. Putting the money into an online savings account is a sensible thing to do, but you might consider a couple of optimizations.

Consider 5-year CD's. While a certificate of deposit will often impose a penalty if you withdraw it earlier than the stated maturity date, the rate of return could still be higher than an online savings account. For example, the rate of return for holding a 2.6% 5-year CD with a 365-day interest penalty would be 1.33% if you held it for 2 years, 1.77% for 3 years, and 1.99% for 4 years. Again, consider carefully your d/c threshold before going this route. If you want to get really fancy in terms of balancing risk and reward, you might also consider a CD ladder.

Consider overfunding your emergency savings and investing in a diversified, conservative stock/bond portfolio. This is a risky move, but if you have a high risk tolerance, a good safety net, and don't anticipate accessing your emergency savings, it can be highly efficient. As outlined in this article on emergency savings by investing company Betterment, if you overfund your emergency savings to the point that your emergencies would be covered even in a downturn, you could earn significantly more than you would even in a long-term CD. Again, this is a risky move, and you should still invest quite conservatively (Betterment defaults to a 40/60 stock/bond split, which they estimate returns an average of 5% over the long term). (Full disclosure: I have used Betterment personally and for my clients in the past. I'm not necessarily recommending them for your emergency savings; rather, I'm referencing the article as a good read on this particular tactic.)

Once you've set up your accounts, how do you maintain them?

Setting up these accounts is only part of the equation; once they're set up, you need to review them on a regular basis (I recommend annually or biannually).

The review process itself is relatively simple: go over your accounts as if you were starting again from scratch. Do you have accounts for every appropriate goal? Should any be added or removed? Are you invested in the right kind of account for each goal? Is the goal being properly funded -- not too much, and not too little?

This review process, while straightforward, is vital. The problem I most often see with tech professionals is overfunded savings accounts. As they climb the corporate ladder, they find themselves with stock options which they (often rightly!) exercise in order to diversify, and then park the proceeds in a savings account until they can determine where to put them. But as they continue to climb the ladder, start families, etc., they no longer have the time they once had to research investment choices...and so their cash position builds far beyond would it should be, and they leave thousands to tens of thousands of dollars of opportunity cost on the table. This is why I highly recommend an IPS, which (among other things) can establish a default location for assets once your known savings accounts are fully funded -- for example, a retirement account.

Of course, savings are just a small part of the optimization available. Choosing your investment implementation and optimizing investment management are even bigger knobs to turn!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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