You have a HYSA (High Yield Savings Account) and you’re earning a few hundred dollars of interest each month - this means you’re all set and can continue going on about your life, right? Not quite. Though, I didn’t have to tell you that. The HYSA is better than nothing, but it’s not the most efficient vehicle to grow your wealth in the long run.
Sometime around 2022, these accounts became very popular as the Federal Reserve raised rates (specifically, the fed funds rate) to fight inflation. As a result, depositors everywhere started receiving actual interest on their savings accounts - something that hasn’t happened since before the Great Recession, in 2007. With a HYSA, you can earn 4-5% per year with the guarantee of FDIC coverage (in case the bank goes out of business) and without investment risk - not a bad deal. Though, it’s natural to ask ourselves, “what is the alternative, am I missing anything?” The answer to this question is an affirmative YES. Let’s look at an example that illustrates the benefits of investing in a Brokerage account over a 10 year period (in most cases, we have even more time than this).
In both scenarios below, you have 100k in cash to start and can save 1k/month:
Scenario 1 (current) - keep adding funds to your HYSA that is paying 4.5% interest per year.
At the end of the 10 year period, you have about 300k.
Scenario 2 (desired) - open a Brokerage account and invest the 100k into a stock index fund (let’s say VTI - Vanguard Total Stock Market Index), which earns 10% per year (this fund actually went up by more than 12% per year on average over the past 10 years - though, prior returns are not indicative of future results).
10 years later, you have around 450k (50% more than above).
Needless to say, this is a sizeable difference. And, we haven’t even looked at the tax benefits yet. The gains (difference between your total contributions and ending value) in the Brokerage account can be taxed at a lower rate (long term capital gains) when compared to the interest earned in the HYSA, which is treated like ordinary income.
Building on the example above, let’s say you would like to liquidate your investment and use the proceeds to buy a house. Your annual household income is 500k and you file your taxes jointly (MFJ - Married Filing Joint) with your spouse.
Scenario 1 (current) - Interest earned over the 10 years is a total of 80k. Your federal tax rate is 35% and therefore you give back 28k of this.
You’re left with about 52k of interest or 272k total for the home purchase.
Scenario 2 (desired) - Gains are a total of 230k and taxed at a long term capital gains rate of 15% - therefore, you give back 35k.
You’re left with 196k of gains or 416k for the home purchase.
By investing the funds in a well diversified stock index, your net gains (after taxes) are almost 4x at the end of the 10 year period. This is not a coincidence - yet, merely the powers of compounding interest and tax efficient investment accounts.
Before you totally eliminate your HYSA and hire a Financial Planner to help you set up a Brokerage account, it’s imperative to note the former has a time and place, just like most accounts in your Plan. We definitely want to continue using HYSAs for your emergency fund (typically 3-6 months of expenses) and any large purchases happening in the next year or so. Though, once we satisfy these items, it’s important to partner with a Planner you trust, invest in the right account, and begin building wealth for the future.
