How Much Cash Should You Actually Keep?

You've probably heard the conventional advice to keep 3 to 6 months of living expenses in an emergency fund, or 6 to 12 months if you have a family or less predictable income.

It's a reasonable starting point. But I've come to realize that our relationship with money often has a bigger influence on how much cash we actually keep.

I've heard stories of people sitting on seven figures in cash, and not even in a high-yield savings account. Not because they have another 10 million invested elsewhere, but because they genuinely don't know what to do with it. Or they're afraid of losing it. On the other end, some people are perfectly comfortable keeping just a couple months of expenses in savings while investing everything else in the stock market.

Neither approach tells us much about someone's financial health without understanding the rest of their situation.

The conventional advice may pass the math test, but it doesn't always account for real life. Job security, family responsibilities, upcoming expenses, and our emotional comfort with money all play a part. So how much cash is enough? And once you've figured that out, where should you keep it?

Let's walk through a fictional family and see how I'd approach this decision.

Meet our fictional family

The following example is hypothetical and provided for educational purposes only. It should not be construed as personalized financial or investment advice. Even households with similar income, expenses, and savings may require different strategies based on their individual circumstances, goals, and risk tolerance.

Imagine a married couple in their early 40s with one child in public school. They live in a moderately priced neighborhood in a high income tax state, earn a combined $200,000 a year, and spend about $8,000 a month.

Over the years, they've diligently accumulated $100,000 in savings.

They like seeing that six-figure balance in the bank. It's reassuring. But lately they've been wondering whether they're being financially responsible or just a little too cautious.

After reviewing their expenses, job stability, retirement savings, upcoming financial needs, and comfort with risk, they decide that 10 months of living expenses, or $80,000, would give them a comfortable safety net.

Here's how they could organize their $100,000 into three buckets:

• Bucket 1: Emergency cash. $32,000, 4 months in a high-yield savings account
• Bucket 2: Backup reserves. $48,000, 6 months in short-term Treasury bills or a government money market fund
• Bucket 3: Future goals. $20,000, save for upcoming expenses, invest for the long term, or enjoy some of it

Let's look at why this might make sense for them.

Look behind the math

The math is easy: $8,000 in monthly expenses x 10 months = $80,000.

But why 10 months? Why not 6, or even 3, considering they both have stable jobs?

You can earn twice what your parents made and still carry the same worries about money that you grew up with.

Maybe your parents often worried about paying the bills. Maybe you experienced financial instability from a divorce or job loss. Or perhaps you grew up hearing that saving money was always the responsible thing to do, while investing in the stock market was basically gambling.

Then there are our own experiences as adults. If you've been laid off before, you probably remember how long it took to find another job. If you've never experienced unemployment, you might feel more confident in your ability to earn.

Someone who grew up with financial instability might need two years worth of expenses in cash to sleep well at night, even if six months would be mathematically sufficient.

I don't believe every financial decision needs to be optimized down to the last dollar. But I do think it's worth asking whether your savings are giving you security or whether fear is keeping you from putting some of that money to better use.

For our fictional family, given their overall financial picture, 10 months feels right. If they were a single income household, I may raise that threshold to a year or more.

There's also a practical benefit to having enough cash: it can help you become a better long-term investor.

When the stock market has a particularly ugly month, it's easier to leave your retirement investments alone when you know the bills are covered. Even if you won't touch your 401(k) for another 20 years, seeing a sea of red when you log in can still make you uneasy.

A healthy cash cushion gives you one less reason to panic when markets are doing what markets do. But what feels healthy is subjective.

But do you know how much you actually spend?

Before deciding how many months to save, you need a realistic estimate of your expenses.

I like to look at a full 12 months of spending and calculate the monthly average. This accounts for seasonal fluctuations like vacations, holiday shopping, and the occasional expensive trip to Costco. And yes, that includes the organic grain-free food your French Bulldog apparently cannot live without.

Don't forget expenses that only come around once or twice a year, like property taxes and auto insurance.

You can certainly calculate a leaner budget by cutting discretionary spending, but I prefer starting with actual expenses.

I know we'd all like to think we'll immediately stop eating out, cancel subscriptions, and become exceptionally disciplined if we lose our jobs. I'm just not sure that's the version of ourselves I'd build an emergency fund around. I'd rather use a slightly conservative estimate, knowing that changing spending habits can be difficult enough without the added stress of a financial setback.

Now, back to our three buckets.

Bucket 1: Keep immediate cash accessible

For our fictional family, the first $32,000 stays in a high-yield savings account (HYSA).

This covers four months of expenses, readily available if something unexpected happens.

Online banks like Ally, Marcus, and CIT Bank often offer more competitive interest rates than traditional banks. Some local credit unions also offer attractive savings rates with the convenience of physical branches, if you prefer doing your banking in person.

Just remember that interest rates can change, and promotional offers may expire after an introductory period.

Certificates of deposit (CDs) are another option. Although this type of account traditionally locks up your savings for a period of time, some banks also offer no-penalty CDs with more flexibility.

Personally, for money I might need tomorrow, I'd rather prioritize accessibility than squeeze out a little more interest.

Eligible bank deposits are generally FDIC-insured, while deposits at federally insured credit unions are generally protected by the NCUA, both subject to applicable $250,000 insurance limits.

Bucket 2: Put your backup reserves to work

Our family has another $48,000 set aside for financial setbacks that aren’t immediate emergencies. They don't expect to need this money immediately, so they have a little more flexibility in where to keep it.

This is where I'd consider short-term Treasury bills or government money market funds.

Treasury bills (T-bills) are essentially short-term loans to the U.S. government, with maturities ranging from four weeks to one year.

For emergency savings, I prefer shorter maturities, typically one to three months. If you hold an individual T-bill to maturity, you receive its full face value. But if you need to sell before then, its price can fluctuate with interest rates.

The longer a bond's duration, the more sensitive its price tends to be to changes in interest rates. Keeping maturities short helps limit that risk.

There's plenty more to discuss about bonds, but I'll spare you the full writeup today.

Money market funds are a type of mutual fund that pools investors' money to buy short-term, relatively low-risk investments, such as Treasury bills and other government securities. Instead of buying and managing these investments yourself, the fund does it for you.

You can purchase any of the above through brokerage firms like Schwab, Fidelity, and Vanguard. There are also short-term Treasury ETFs, such as SGOV or VBIL, that hold a collection of T-bills and manage them for you.

One reason I like having these alternatives available is that the best place for cash isn't always the account posting the highest interest rate.

Why taxes matter more than you might think

Let's go back to our couple, who earn $200,000 a year. If our couple kept their entire $100,000 in a high-yield savings account earning 3.5% APY, they'd earn $3,500 in annual interest, assuming the rate stayed constant.

Not bad, right?

But after federal and state income taxes (assume CA), they'd keep only about $2,405. That 3.5% yield is now effectively 2.4% after taxes.

And here's the kicker: according to the latest inflation report released in October, consumer prices rose 3.7% over the past year. If inflation continued at that pace, their savings would lose purchasing power even as the account balance grew.

That's why I think it's worth paying attention to what your savings actually earn after taxes, rather than just looking at the advertised interest rate.

This is where Treasury bills may have an advantage.

Unlike savings account interest, interest earned on U.S. Treasury securities is exempt from state and local income taxes. So even if a Treasury bill and a savings account offer the same pretax yield, our California couple could keep more of their earnings with the Treasury bill.

The difference may not be enormous, but it's worth knowing when you're deciding what to do with a substantial cash reserve.

There's a trade-off, of course. T-bills can fluctuate in value if sold before maturity, although shorter maturities generally mean smaller price swings. Treasury-focused money market funds may also provide state tax advantages, depending on their holdings and applicable tax rules.

The goal isn't to chase the highest yield. It's to keep the money accessible and reasonably protected while being thoughtful about what inflation and taxes are doing to its value.

Bucket 3: What about the remaining $20,000?

Our family now has $80,000 set aside as a safety cushion, leaving $20,000 of their original savings. Next, I'd turn the conversation away from emergency funds and toward the rest of their lives.

Do they need to replace an aging car in the next year or two? Is their HVAC system approaching retirement? Or planning a larger-than-usual family trip?

If they expect to spend that money soon, keeping it in an HYSA, CD, or Treasury bill timed to mature before the expense would make more sense than investing it in stocks.

But if they don't have major purchases coming up, already have adequate cash reserves, and continue to save extras from their disposable income, perhaps it's time to consider investing some of it for longer-term goals.

Here's another possibility: maybe they don't need to save or invest every dollar of that remaining $20,000.

Perhaps there's a trip they've been putting off, a home improvement that would make daily life a little easier, or something meaningful they've wanted to do as a family.

I think of cash reserves as the foundation of a house. You want a foundation that's solid enough to support everything you're building. But continuing to pour concrete long after the foundation is finished doesn't necessarily make it a better home.

At some point, you get to build the life that goes on top of it.

Of course, that point looks different for everyone. I'm not suggesting our fictional couple should spend the whole $20,000. Their other financial goals, retirement readiness, and priorities would help determine what makes sense.

Finding your own safety number

Our fictional family's three buckets aren't a formula to copy. They're an example of what happens when you give your savings a purpose.

Start with what you actually spend, consider the uncertainties in your life, and decide how much cash would let you sleep comfortably at night.

Then think about which dollars need to be available tomorrow, which can sit in backup reserves, and which could be doing something else for your future.

You don't need a complicated system to make thoughtful decisions about your money.

And when saving more becomes a choice rather than a necessity, perhaps it's time to ask yourself: what else could my money make possible?

Now let me ask you, without knowing exactly what your monthly expense is, what is your safety number? If enough of you respond, I'll share the results in the next newsletter!