Saving means putting money aside gradually in a secure place, such as a bank savings account. These accounts often have low interest rates compared to other investment options, such as certificates of deposit or money market accounts.
Saving also has a disadvantage, because it typically does not keep pace with inflation. This can reduce the buying power of your money.
Interest Rates
Savings accounts are a great option for storing your spare cash because they typically offer ready access and come with very little risk. They are also often offered by brick-and-mortar banks and credit unions, and are FDIC-insured. However, the interest rates they pay on your savings can be quite low.
As of mid-2023, the average savings account paid only 0.01% to 0.15% in annual percentage yield (APY). High-yield accounts are available but may require you to meet certain requirements, such as a minimum balance or limit transfers and withdrawals to six per month. Some online-only banks have higher APYs but usually at the cost of limited accessibility.
The disadvantage of saving is that your money doesn’t grow very fast, and may even shrink in real terms thanks to inflation. For example, if you save $100 in January, it may only buy $98 worth of goods and services by the end of the year due to inflation.
Investments, on the other hand, can help you make your money work harder and reach longer-term goals. They can also offer potentially higher returns than savings accounts, particularly if you allow your investments to compound, meaning that the income they generate is re-invested. However, investing can be more volatile than savings and you should only consider it if your financial goals are long-term.
Taxes
Savings accounts are great for putting aside money for expenses you may face in the near future. They also help you save for bigger financial goals, such as a down payment on a home or retirement. Savings accounts keep your money accessible and easy to withdraw, which can be helpful in the event of an emergency.
However, savings accounts are often subject to minimum balance requirements, which can make them less flexible than other types of investments. In addition, they typically offer low interest rates compared to other investment options.
Another drawback of savings accounts is that any interest you earn is taxable by the IRS. This can reduce your overall returns. Generally, the IRS taxes interest at your earned income tax rate for the year, and the amount you owe will depend on your total taxable income for that year, your current tax bracket and how much you earn in interest each year.
There are some types of savings accounts that can help you avoid paying taxes on your interest, such as tax-free savings accounts. These accounts are designed to encourage savings for things like retirement, education and healthcare, and they offer special tax treatment that can make them more attractive than traditional savings accounts. To choose the right type of account for your needs, consider your short-term and long-term financial goals, as well as your risk tolerance.
Inflation
Inflation can take a big bite out of the value of your savings. If you’re saving for a specific goal, such as a vacation or a new car, and inflation rises at the same time, your funds will buy less in the future than they do now. That’s because rising prices raise the cost of goods and services, so you need more money to purchase them.
High inflation is especially dangerous for retirees who rely on savings to cover expenses like medical costs and food. If you’re saving for a long-term goal, such as retirement or a child’s college education, you can offset inflation by investing in stocks, mutual funds and other growth-oriented assets that have historically earned more than the rate of inflation.
Inflation also hurts the purchasing power of cash, which is why it’s important to find a savings account that pays high interest rates. Online banks typically offer savings accounts with much higher interest rates than traditional banks, and the best savings accounts pay rates that beat inflation. When choosing an account, make sure it offers easy access so you can use the money quickly if needed. And beware of fees that can eat into your earnings. You should avoid any account that charges transaction or maintenance fees. That includes checking accounts, credit cards and even some mutual funds.
Risk
Savings accounts are safe and secure places to tuck away cash that you don’t plan to spend right away. These bank accounts usually pay small amounts of interest, and they’re FDIC-insured up to $250,000 per account holder in case your bank fails. This makes savings accounts a great option for stashing funds for specific goals, such as an emergency fund or vacation, or for money you plan to use within the next few years.
However, there are risks to consider when saving cash in a savings account, including lower than average interest rates and the risk of inflation eating away at your purchasing power over time. In addition, many savings accounts come with certain limitations, such as a minimum dollar amount required to open the account, a maximum number of withdrawals or transfers each month and other restrictions.
Fortunately, higher-yield savings accounts exist that can help your money grow faster than traditional bank savings options. Online banks and credit unions often offer better rates than traditional brick-and-mortar institutions, and you can find accounts with a variety of terms to meet your needs. When shopping for savings accounts, look for one that offers tiered interest, which provides a higher rate as your balance grows. Also, look for an account that doesn’t charge any fees or minimum balance requirements.