The Cash Trap: Why Sitting in CDs (or Money Markets) May Cost More Than You Think

Key Takeaways   

• Short-term cash can be useful when planning for major one-time expenses. 

• But, after inflation and taxes, CD and money market returns are often negligible, quietly eroding your purchasing power over time.  

• A coordinated financial plan, cash flow plan, and investment plan help avoid the trap of holding too much idle cash and gets you to your goals. 

One of the most frequent questions I’ve heard lately is: “How can my investments be performing so well with everything going on in the world?” It’s always nice when clients are pleased with the performance of their investments. However, many investors who aren’t working with an advisor may have missed out on huge gains in recent years because they’ve had a large part of their wealth sitting in money markets, CDs, or short-term Treasuries waiting for a better time to invest.  

Missed Opportunities Based on Fear  

After the global financial crisis of 2008-2009, interest rates in the US were historically low for an extended period of time. People grew accustomed to near-zero or 1% rates on CDs. But, after an abrupt rise in inflation and short-term interest rates following the pandemic, we saw CDs start to pay around 4%, which became attractive to some conservative investors. However, in the search for safety, these investors have missed out on double-digit returns from the global stock market.   

Having a cash flow plan, an investment plan, and a financial plan all working together helps people avoid the trap of accumulating too much in short-term reserves. CDs and other short-term investments are great options when you need to set aside cash for large upcoming expenses. But once you have enough earmarked for those expenses, it’s best to invest your remaining cash to obtain a higher rate of return.  It’s natural to want to be more conservative with your money if you’re retired or approaching retirement, but you can't just go into a shell and avoid risk. It is important to own enough higher-returning investments to stay ahead of inflation and make sure you don’t outlive your money. 

Reinvestment Risk  

Another thing that many people don’t realize when they seek the safety of CDs and short-term Treasuries is that those instruments can mature before you know it. Many people opt for six-month to twelve-month CDs. When it comes time to roll them over, the yield may be significantly less. For instance, the Federal Reserve is decreasing interest rates at the short end of the yield curve. Someone may have owned a 4% CD over the past year, and now they go to reinvest, and rates for the same CD have fallen to 3.5%, 3.25% or even less. With the Fed likely to implement several more rate cuts over the next year, investors in short-term cash instruments are facing “reinvestment risk.”  Many CD holders forget that if you don’t act, banks will automatically renew your CD. If you take no action, those CDs renew year after year, and you are barely keeping up with inflation.   

Inflation Drag 

Prices for housing, energy, groceries, and so many other goods and services are at elevated levels.  If you have a large portion of your wealth tied up in CDs, you’re effectively earning less than 1% after inflation, and that’s before you’ve even paid any taxes on the interest!  

This situation is especially concerning if you’ve just sold your business or have received a substantial bonus or restricted stock from your employer. You may be sitting on hundreds of thousands of dollars, even millions, in “safe” CDs or money markets, "waiting for the right time” to invest. This waiting can end up costing you hundreds of thousands of dollars a year or more.  

I remember at the end of 2022, we had a significant down year in both the stock market and bond market. Many financial pundits were convinced we were on the verge of a recession, and many investors fled to the safety of cash to ride out the potential storm. Instead of a recession, however, we experienced continued economic growth, and the stock market had three straight years of substantial positive gains. No one knows how long stocks will continue to perform well. The next downturn will likely be sudden and unpredictable, but we do know that over time we expect the global stock market to have higher returns that our clients need for their financial plans to be successful.  

Tax Considerations 

 Another drawback to keeping so much of your money in “safe” CDs and money markets is that all the interest income you earn is taxed as ordinary income. Instead, you might benefit from tax  

strategies like investing in (tax-free) municipal securities or doing a Roth conversion. When you have more tax-free income, you can utilize more of your standard deduction or itemized deductions to offset ordinary income. You could be realizing capital gains at a 0% rate instead of 15% or 20%. There are many fun things you can do from a tax planning standpoint. But if you’re in a higher tax bracket and you have income from CDs or money markets, it’s a sub-optimal strategy. 

Conclusion  

The lack of a plan often leads to indecision or taking too many actions during times of volatility and stress. Novi clients have carefully tailored financial, cash flow, and investment plans. They know when cash becomes available, it is time to give us a call so we can advise on the optimal strategy for savings and investment consistent with their big picture financial strategy. Many high-net-worth individuals have so many different types of accounts and money spread across so many different places that it becomes difficult to maintain.  Many business owners feel like they have so much risk in their business that they need to be overly conservative with their investments. However, these investments aren’t keeping up with inflation, much less building real diversified wealth over time. 

If these situations sound like you, contact me anytime to review your allocation or long-term financial plan.  

Contact Us

RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth