December 16, 2024
Hold too much cash, and you’re comfortably losing money to inflation. Hold too little cash, and you’re running the risk of being unable to deal with unexpected expenses. A good plan for managing existing cash and current cash flow balances three factors: financial planning best practices, your comfort with cash, and an active approach to managing cash on an ongoing basis. In practice, your cash flow surplus determines how quickly your cash reserves grow—or become depleted. A good financial plan will reveal this to you.
Consider the equation: total inflows minus total outflows equals net cash flow. When you’re operating in a cash flow surplus, your current cash reserves grow by this amount annually. When you’re in a cash flow deficit, your cash reserves are depleted by this amount each year. For example, let’s assume $755,566 in total annual expenses. Financial planning best practices recommend having 3–6 months of living expenses on hand. For dual-income households, 3 months of expenses is generally sufficient. However, if 80% of the total income comes from one household member, it’s best to hold closer to 6 months. In a dual-income household with fairly even income distribution, 3 months of living expenses would amount to approximately $83,000 in cash reserves for this example.
It’s important to note that taxes, such as the $340,801 included in the example, are excluded from this calculation because taxes are not an expense incurred on lost income. In plan recommendations, I prefer giving a range of recommended cash reserves. For the example above, this range would be $66,000–$100,000, allowing for a 20% standard deviation from the recommended 3-month reserve to account for life’s uncertainties. This recommendation is always paired with a conversation about the client’s comfort level with cash. If a client prefers to hold 6 months instead of 3, I seek to understand their perspective and adjust my recommendation as needed.
When cash reserves exceed 7 months or fall below 2 months of living expenses, I initiate a conversation about their goals to guide action. If I’m successful in guiding action, that’s a win. If not, no problem—that’s what makes personal finance personal. I document this in their financial plan and move forward. Once cash recommendations are met, the goal is to ensure the reserves earn the highest possible rate of return. At a high level, I apply the Pareto principle (80/20 rule) to cash holdings: 80% of total cash should be in high-yield savings or a money market account, while 20% should remain in a checking account for liquidity. You don’t need the full amount sitting in your checking account, but it should be liquid and not subject to market volatility.
As of November 10, 2024, 1-month treasury bills are generating 4.51%. Using our example, this means allocating $66,400 (80%) to a money market account and $16,600 (20%) to a checking account. This setup allows the money market portion to earn 4.51% annually, generating an additional $2,994 in interest, while the checking account holds funds for regular spending. To achieve favorable money market rates, it’s likely you’ll need to open a brokerage account and invest in a publicly traded money market fund. Traditional banks offering such rates are rare, as banks profit from paying you less than they earn.
If your cash reserves are below the recommended emergency fund levels, your plan should outline how to replenish them through a cash flow surplus. Conversely, if your plan reveals a cash flow deficit, you’ll need to reduce spending or increase income to build your reserves. If you’re holding cash above recommended levels, the plan should include steps to sweep excess cash into accounts or assets with higher expected returns, such as retirement or brokerage accounts, real estate investments, or other ventures, depending on your goals. For example, if $100,000 is held in cash, the recommendation would be to allocate $17,000 to these areas.
The magnitude of your cash flow surplus may also affect how quickly reserves are replenished, allowing for more aggressive allocation of excess cash. However, the other part of the planning process would focus on putting the surplus to work, making this a non-issue. Above all, the goal is to maintain a functioning cash flow system. Regular check-ins—typically at 4 and 8 months after a formal annual review—ensure cash reserves are monitored at least three times per year to guide action. When emergency funds are low, replenish them. When funds are high, sweep the excess to other accounts. Always keep emergency funds in high-interest accounts.
This approach may seem simple in theory, but it is powerful in practice. The efficiency created from earning higher returns on cash and putting excess funds to work can add thousands—or even hundreds of thousands—of dollars to your net worth. This is the true power of cash flow planning.