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Ask Money

Medium-term savings

Chris Farrell Aug 11, 2009

Question: I am a 24 year old engineer who has been extremely fortunate in this economic downturn. My wife and I have no college or credit card debt and a combined income of 100k. Up to this point the majority of our savings has been in retirement accounts, such as 401(k)’s and our Roth IRAs. We also have begun to build an emergency fund in a money market account for short-term savings. The glaring weakness I see currently is medium-term savings, such as for our next house or car in 5-10 years. My hunch is that some low-cost index funds are the way to go right now. Is this the right overall investment strategy to be taking in the short, medium, and long-terms? Adam, Hamilton, OH

Answer: You’re smart with your money and you have a good savings strategy. Here’s a suggestion for your medium term savings. I like the idea of investing in a low-cost broad-based equity index fund in a taxable account. Your annual tax liability is fairly small, most reflecting dividends payments. The capital gains impact is minimal since index funds mostly don’t sell their holdings unless it’s to take into account changes in the underlying index. You’ll face the capital gains tax hit when you sell shares, assuming the investment has appreciated in value over the years. I like the idea of setting up an automatic investment plan so that every month a small sum of money goes out of your checking account and into the index fund.

You can complement this risky slice of your savings portfolio with an investment in I-bonds. It’s an inflation-protected savings bond. There are no commission costs to buy and sell I-bonds. You can buy $5,000 online in electronic I-bonds directly from the U.S. Treasury and another $5,000 in paper I-bonds from your bank or credit union. Your money compounds tax-deferred and you don’t pay Uncle Sam at your ordinary income tax rate until you cash them in. If you sell the I-bonds before 5 years you’ll lose three months interest as a redemption penalty. There is no penalty after 5 years. To be sure, I-bonds aren’t in favor right now because the rate is zero. That’s right, 0%. The rate reflects the steep decline in the consumer price index during the Great Recession. The reason it doesn’t bother me is what if inflation surges in a year, three years, or five years from now? The dollars you put aside today will be protected against inflation, at least as it is measured by the consumer price index.

By the way, I look at this approach as a 5+ years strategy, especially with the index fund. If your time horizon is less than 5 years the stock market is simply too volatile a place for savings. .

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