A lot of cash - too much risk

NEW YORK (Money) -- Question: My husband likes having cash on hand, so we put about 20 percent of our salary into a money market account every week. I'm concerned, however, that the money won't grow enough to help us retire. Neither of us contributes to a 401(k), but we plan on doing that soon. What would you suggest we do? - Deborah D., Columbus, Ohio

Answer: I share your concerns. Keeping cash on hand to take care of emergencies or to tide you over in the event of a layoff is smart. But it seems your husband may be taking a good idea too far.

Once you've got three to six months' worth of living expenses stashed away, you've probably got all the reserve you need. And if you keep plowing more and more money into low-return options, you run the risk that your savings won't grow enough over the long-term to allow you to maintain your lifestyle in retirement.

To see what I mean, let's do a quick back-of-the-envelope analysis.

Money market accounts now sport annualized yields of roughly 4 percent or so. If you're in the 25 percent tax bracket, that brings your after-tax yield down to 3 percent. Subtract 2.5 percent for inflation, and the after-tax purchasing power of your money is really only growing by about a half a percentage point a year.

Granted, money market yields and inflation are changing all the time, so you might do better in some years. But history shows that highly secure investments generally don't pay very much more than the inflation rate over the long term. Which means that your husband's desire to have lots of cash on hand essentially relegates your money to a relatively meager return, and stunts the growth of your retirement nest egg.

By contributing to your 401(k), by contrast, you stand to gain several big benefits. To begin with, you get an immediate tax break. You contribute pre-tax dollars to your 401(k), which trims your tax bill.

Yes, you do pay tax on your 401(k) funds when you withdraw them. But for all the years the money is in there, it grows without the drag of taxes. Over time that can appreciably boost your after-tax rate of return.

Your 401(k) plan also likely gives you access to a decent menu of stock and bond mutual funds. Over many decades, the annualized gain on stocks has outpaced that of inflation by about seven percentage points, while bonds have outrun inflation by more like two and half to three percentage points.

Although there are no guarantees, the odds are extremely high that a diversified portfolio of stock and bond funds will earn a higher long-term return even after taxes and inflation than any money market account. (For guidance on how to create a diversified portfolio in your 401(k), check out our Asset Allocator tool.)

Of course, the financial markets can get stormy from time to time, so you'll have to weather some ups and downs. But when you're investing for a long-term goal like retirement, the more important task isn't avoiding occasional short-term setbacks; it's making sure you end up with a nice big fat nest egg at retirement time.

And as if that's not enough, your 401(k) may come with another bonus - most employers match 401(k) contributions.

Throw in convenience - your 401(k) contribution is automatically taken out of your paycheck, so there's no need to write a check to the bank - and a 401(k) is about the closest thing there is to a no brainer in the world of finance.

So I suggest that you and your hubby sit down and figure out how much money you realistically need in that money market account. Figure three to six months' of living expenses, and, if they apply to your situation, you can also throw in any big financial commitments you think you might make over the next couple of years, such as a house or car down payment.

Beyond that, though, you should start socking away at least enough in your 401(k)s to get the maximum match. If you still can save after that - and it sounds as if that may be the case - then move on to a Roth IRA, where you can salt away as much as $4,000 this year. (People 50 and older can also do another $1,000 in "catch-up" contributions.)

And if you've still got cash you can tuck away, then fund your 401(k) to the max and, after that, you can look into other options I've mentioned in a previous column.

If all this makes your cash-conscious husband feel a bit uneasy, well, just tell him that by following this strategy he'll be able to have a lot more cash on hand when he really needs it-in retirement.

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