How to Invest Money That You'll Need in a Year
One of the primary factors determining investing strategy is your investment time horizon.
It’s one of the major components in deciding how much risk you should take on.
If your time horizon is 20 or 30 years out, you’ll naturally want to invest more heavily in equities to improve your long-term return.
But the situation is entirely different if you want to invest money that you’ll need any year.
Sure, you’ll certainly want a healthy return on your investment.
But capital preservation becomes even more important. After all, while you might be able to ride out market downturns over several decades, that will be possible in a year or less.
With that in mind, let’s look at the best places to invest money that you’ll need in a year, considering both the safety of principal and investment return.
1. Certificates of Deposit (CDs)
In a real way, CDs are the ideal place to invest money that you’ll need in a year.
You can invest in a 12-month certificate that will provide you with both a guaranteed return and full protection of principal.
The highest yields available are through online banks.
2. Money Market Funds
Money market funds are essentially mutual funds comprised of interest-bearing short-term securities.
They’re mostly designed as a component of portfolios filled with mostly stocks and bonds. They provide a cash equivalent for investors to park their money in between investments.
Some provide impressive yields, especially when compared to local bank savings accounts and money markets.
They’re a solid choice if you anticipate interest rates rising in the coming months.
Since they regularly turn securities in their portfolios, they’ll be able to adjust to rising rates on a continuing basis.
3. U.S. Treasury Bills
The U.S. Treasury issues interest-bearing securities ranging in terms from 30 days to 30 years, and just about everything in between.
They’re seen as the safest of all investments because they’re considered immune from default (though longer-term securities do have interest rate risk due to fluctuations in interest rates).
Because of their safety, U.S. Treasury bills are well-suited to invest money that you’ll need in a year.
“Bills” are securities with terms ranging from 30 days to 52 weeks. (Terms from two to 10 years are “Notes”, and 30-year terms are “Bonds.)
The one year Treasury Bill typically yields excellent returns on a short-term investment with a guaranteed return principal.
But if you’re concerned that interest rates will go up in the coming months, you can play Treasury bills a little bit different.
For example, you can just hold your money in a three-month Treasury bill.
If interest rates rise, you’ll be able to renew your investment at future higher rates every three months. The average return may be higher than what you can get on a 12-month Treasury bill.
But just be aware that outcome is not guaranteed.
You can purchase, hold and redeem Treasury bills through the US Treasury’s investment portal, TreasuryDirect. They can be purchased in amounts as low as $100.
4. Money Market Accounts
Money market accounts are provided by banks. They have the advantage of being completely liquid, a lot like a checking account.
Much like money market funds, they’re good choices if you anticipate rising interest rates in the coming months.
They’ll automatically adjust with higher rates as they become available.
The downside is that local banks pay something close to nothing on them. You may get a yield of something like 0.15%, which is hardly worth the investment.
But there are online banks that provide returns many times higher.
Be aware that yields on money market accounts vary by the amount of money you invest.
For example, you may need to invest, say, $10,000, to get the best yield.
5. Online Savings Accounts
There’s not a whole lot of difference between money market accounts and savings accounts anymore.
But one parallel you should be aware of is that the same local banks that pay pitifully low rates on money market accounts, pay the same kind of yields on savings accounts.
The better option once again is online savings accounts. Not only do they pay higher yields, but they’re available to investors on a nationwide basis.
Once again, much like money market accounts, yields on savings accounts are often tied to the amount of your investment.
As well, a bank may offer an attractive rate for a limited time, like six months.
But even if it does, you can take advantage of that rate while it lasts, then switch to another online bank savings account.
6. Short-Term Bond Funds
Short-term bond funds typically invest in bonds that are due to mature within one to three years.
For example, a fund may hold a 20-year bond purchased at the end of year 18, and due to mature in two years.
The object is to secure the higher yields that bonds provide (over short-term securities) while minimizing potential loss of principal from interest rate risk.
Morningstar has an outstanding Short-Term Bond Total Returns chart that’s worth checking out if you’re interested in investing in this asset class.
It provides returns for hundreds of funds, providing returns for one month, three months, one year, three years and five years.
But be careful – yields on bond funds of all types can take wild swings.
A fund yielding 3.5% today, may be yielding only 0.57% six months from now. In fact, according to Morningstar, the average annual yield on all short-term bond funds is just 0.23%.
As you can see, you’re taking on added risk with short-term bond funds. If you’re willing to take that risk – in the hope of getting an above market return – go for it.
But if you’re looking to fully preserve your capital you’ll be better off with the other investments on this list.
What You’re Aiming For
With confidence in stocks as high as it’s been for the past few years, people often consider keeping short-term money in the market.
After all, the reasoning goes why put money in a CD, when I can get 10% or more in stocks in one year?
That’s the kind of thinking prolonged bull markets produce. But it’s not well advised when you’re looking to invest money that you’ll need in a year.
Even if the market does produce a 10% return for the full year, there could be a 10% loss along the way, that causes you to sell out in a panic.
When you’re looking to invest money that you’ll need in a year, keep the following in mind:
Low risk/safety of principal
If you need the money in a year, there won’t be enough time to recover losses in principle.
A significant loss of that principle could change whatever plans you had for the money.
When it comes to short-term investing, preservation of capital is even more important than investment return.
Sure, you can get higher yields by investing in longer-term securities.
But that might present a problem when you need the money one year from now.
And if interest rates rise, you could also experience some loss of principal on an early sale of the security.
Unfortunately, a dollar today won’t be worth as much one year from now.
That’s a result of inflation.
For that reason, you’ll want to make sure the return on your investment is something approaching the rate of inflation. Earning interest is more about preserving the value of your investment than it is about growing it.
Moral of the story: when you invest money that you’ll need in a year, it’s always best to be more conservative.
What About Retirement Accounts?
Another popular perception/practice is tapping retirement accounts for short-term financial needs.
While it seems easy and convenient, it’s not without problems.
Consider the following common retirement account cash sources:
If you withdraw money from an IRA, you not only have to pay ordinary income tax on the distribution but also a 10% early withdrawal penalty if you’re under age 59 ½.
There are exceptions to the early withdrawal penalty – like withdrawing up to $10,000 to buy a first home. But you’ll still have to pay ordinary income tax on the withdrawal.
It’s simply not a cost-effective way to raise cash for short-term needs.
These work better for early withdrawals.
Since contributions aren’t tax-deductible, they can be withdrawn at any time, without being subject to either ordinary income tax or the 10% penalty.
This is due to the IRS Roth IRA ordering rules – contributions are always withdrawn ahead of investment earnings.
It actually makes Roth IRAs a potentially viable source of short-term cash.
401(k) and 403(b) plans
You can get around the tax consequences by doing a loan, rather than a plan distribution.
Under IRS rules, you can borrow up to 50% of your vested plan balance to a maximum of $50,000, then make repayments in as long as five years. As of March 27, 2020, the coronavirus emergency stimulus bill allows those affected by the coronavirus situation a hardship distribution to $100,000 without the 10% penalty those younger than 59½ normally owe; account owners have three years to pay the tax owed on withdrawals, instead of owing it in the current year.
Even though you can get short-term money out of a Roth IRA or a 401(k) or 403(b) plan, it’s not usually the best long-term strategy.
In the case of a Roth IRA, there may be no tax consequences, but you’re reducing the plan’s primary purpose of providing for your retirement. And with a 401(k)/403(b) loan you’re reducing the return on your plan, which also impairs your retirement.
Taking withdrawals or loans from any of these plans can actually cost you more money than you think.
For most people, CDs, online savings accounts, money market accounts and U.S. Treasury bills will be the best way to invest money that you’ll need in a year. All offer respectable returns, as well as the complete safety of principal.
You can shoot for somewhat higher returns with short-term bond funds or money market funds, but neither the returns nor the principal invested will be guaranteed a year from now.
If you have a definite need for money in a year or less, it’s best to go with what’s guaranteed and save any risk-taking for longer-term investments.