A few weeks ago I said the “stock market is not a good match for investment time horizon.” That’s because there can be long stretches of negative or flat returns, and at the beginning you don’t know how a particular time period will pan out.
So what if you are setting money aside for something soon or soon-ish? If you’re talking about the something within the next 12 months, or where you might need the money right away (like for an emergency fund), I’d suggest a high-yield savings account (I personally use Ally, there are other good ones) or a money market fund (I currently have money in a Vanguard money market mutual fund, again, there are other good ones).
What about saving for something a little further out, like 2 or 3 or 4 years from now? One option is a CD (certificate of deposit). CD rates are as high as 4% or 5% right now. The way a CD works is: you put in a certain amount, say, $1,000. Then you earn interest on it at the stated rate for the stated period of time (the “term”). So if you invest $1,000 in a 1-year CD and it has a 4% rate, after one year the CD “matures” and you get back your original $1,000 plus interest of $40 (=4% * 1,000). You’ll pay federal and state income tax on that $40 of income at your regular income tax rate, so the after-tax rate might be something like 2.8%. If you end up needing the money back sooner than the term, you can break the CD and just forfeit a few months of interest. CDs will have a minimum purchase amount such as $500 or $1,000.
What if you aren’t exactly sure when you’ll need the money, or your time period is between that of CDs? Let me introduce you to the humble I Bond. These are savings bonds issued by the U.S. Treasury and the “I” stands for inflation. They are old-fashioned savings bonds, except with modern and awesome inflation protection.
The interest rate of I bonds has a fixed component which is set when the bond is issued to you, and a variable component which is determined by inflation. Right now i bonds have a rate of 4.3%. The fixed component is 0.90% and the variable inflation component is 3.4%. If you bought an i bond right now, and in a year inflation rose from 3.4% to 5%, the i bond’s rate would rise to 5.9% (=5% variable component + 0.9% fixed component).
You are required to hold an i bond for at least 1 year. If you sell before 5 years you forfeit 3 months’ of interest. Right now, 3 months of interest on $1,000 of i bonds would be about $11 (=4.3% * 1,000 * 0.25 years). You pay tax on the interest only when you cash out (redeem) the i bonds, but only federal tax (it is exempt from state and local income tax). You can purchase as little as $25 or as much as $10,000 in one calendar year from TreasuryDirect.gov, and if you really love them, you can also buy up to $5,000 of i bonds with a tax refund.
I buy i bonds every year as one component of my investment portfolio (within the bond part of my portfolio) and plan to hold them long term. There are multiple ways you could use i bonds.
One of my favorite finance writers, Harry Sit, has a comprehensive article on buying i bonds which I recommend if you are interested. Another great resource on the technical side is David Enna’s TIPS Watch blog.
The primary downside of i bonds is that the Treasury website is not as easy to navigate as what we are used to from most banks and investment firms. There is no snazzy app! Nobody makes money off selling you i bonds. They are extremely boring.