Q&A: Should I Invest Money I Need in Two Years?

Q: I just started my first full-time job (this Monday!) and found your blog doing a search trying to make sense of my 401(k) options. I have been so inspired reading all over your blog since then and learning more about investing and saving for retirement.

I have a specific question about one of my savings goals. I want to have $18,000 saved within two years to pay for an accelerated nursing degree program. I’m $3,500 in so far and planning to contribute a lot in the next few months while I’m still living rent free. After that, I can hopefully save $500 a month. I currently have this money in an ING savings account at 0.75 percent interest but I’ve been inspired to consider investing it. The problem is my goal time frame is right around the cusp between the short- and mid-term time periods, so I’m not sure which advice to take. This would be my first investing experience and I’m afraid to risk it on a goal that is so important to me. I’ve been considering Betterment but I would be very grateful to hear from you first. –Grace

A: Contrats on the new job and your plan to save for your advanced degree. A lot of people don’t think twice about borrowing “whatever it takes” to go to graduate school. Depending on the degree in question, those student loans may or may not be worth it in the long run, but either way they will set you back financially for a number of years. If you can stick with your plan to save a large chunk of your tuition you’ll be that much better prepared to make your future earnings work for you when you graduate.

Now, about whether to save or invest.

As you recognize, putting your money in anything but an FDIC-insured savings account always involves risk. So you have to ask yourself if the risk of losing some of your money is worth the extra return you could get by investing it. Let’s look at the numbers:

• If you start now with $3,500 and put in $500 a month in the ING account at 0.75 percent, you’ll have about $15,640 in two years.
• If you invested in mostly bonds and some stocks to hope for a return of 4 percent, you’d have about $16,200 in two years. Of course, a 4 percent return is optimistic — you might get closer to 2 percent, and there’s always the chance your investments could be flat, or even down, at the end of the period.

There’s one final consideration: Taxes. Savings interest is taxed at your marginal income tax rate. Any gains on investments you hold longer than one year as well as qualified dividends, are taxed at the lower capital gains rate. Regular dividends and investments you hold for less than one year are taxed at your income rate, as well. The bottom line is there is room to save a bit on your taxes by investing rather than saving.

So, if you’re going to invest the money, where should you?

You mentioned Betterment, which is a simple way to invest. I would pick an allocation that’s 70 percent bonds and 30 percent stocks. The platform makes it easy to set up monthly auto-deposits and adjust this allocation if you ever need to.

Another option is to open a direct mutual fund designed for a short-time horizon. By investing directly with the fund company you should be able to set up automatic deposits. One such fund is the Vanguard LifeStrategy Income Fund. There’s a $3,000 minimum to open this fund, but it sounds like you have that covered.

Whether to save or invest all comes down to your risk tolerance: By investing in a diversified account like the ones above, you protect yourself as best you can, but there’s always the chance that your account will be flat or even down when it comes time to go to school. If that’s too scary, stick with a good-old ordinary savings account.

As one final alternative, if you dont’ mind a little extra paperwork to earn a few extra dollars, you could take the $3,500 you have now and open a two year certificate of deposit (CD).

Continue to add to your savings account each month for another year, and then open another one year CD with that money you’ve saved. I typically don’t recommend CDs to young savers, and the reason is simple: if you ever need the money you put into the CD for something else, you can’t withdraw it without paying a penalty. With the difference in rates between regular savings accounts and CDs so thin, this is a big downside for a little bit of gain. Your situation, however, a defined two-year savings timeframe, is a worthwhile exception to this rule.

What do you think? Would you invest for a goal that’s just two years away? How do you maximize your returns for short-term savings goals?