For the second in my three-part series on saving, I am going to focus on different account options for saving money. When considering how and where to save your money, I think that one of the most important factors is your time horizon. If you need the money soon, or you aren’t sure when the need will arise but you want to maintain liquidity, the savings vehicles that you may use are different than those used if you are saving for a goal far in the future with a set end date.
Once you have established the goal or goals you are saving for, the next step is to determine when you hope to reach the goal. I find it is helpful to break goals into three categories, short-term goals are those you hope to reach within one year, medium-term goals are those that are one to three years from completion, and long-term goals are those that will take you more than three years to reach. After you have established your time horizon, it is time to select your method of savings. I am going to describe some of the most common savings methods as well as the advantages and disadvantages of each.
Savings accounts are one of the most familiar savings vehicles. These accounts can be at your bank linked to your checking account or online and offer a small amount of interest on the money you keep in the account. Often savings accounts at brick and mortar banks have lower interest rates than those online (this isn’t always the case). For a good online bank that offers decent interest I often recommend my clients consider Ally Bank at www.ally.com(please note that I have not received any compensation for this recommendation). I use Ally for several of my medium-term savings goals. Savings accounts are ideal for short-term and some medium-term goals, or to hold your emergency fund to maintain liquidity. These accounts give you access immediately to your money should you need it and there are no withdrawal penalties.
One important thing to note about savings accounts is that they limit your activity to six convenient withdrawal transactions per month. This limit is in response to federal regulation and if you exceed it the bank will likely charge you a fee.
Money Market Accounts
An alternative to a savings account that has many of the same benefits is a money market account (MMA). This account also accrues interest on money deposited and comes with limited check writing or debit card privileges. Typically, the interest rate for a money market account is higher than a regular savings account. This higher interest rate makes a money market account a good savings vehicle for short-term and medium-term goals. It is important if choosing a money market account to understand that there is a transaction limit associated with this account type as well. Money market accounts limit account holders to six transfers and electronic payments per month. This includes pre-authorized transfers, electronic transfers, telephone transfers, checks, debit card payments, ACH transactions, and wire transfers. If the six-transaction limit is exceeded, account holders may have a fine assessed and ultimately, if the limit is exceed on a regular basis, may have their accounts closed. Deposits and withdrawals made in person and via the ATM are not limited.
Certificate of Deposits (CDs)
Another option for saving is a certificate of deposit or CD. CDs are savings accounts that are insured by the federal government. But unlike regular savings or money market accounts, CDs have a fixed interest rate and a fixed withdrawal date, or maturity date. The rate of interest received on a CD is related to the time that the account holder agrees to leave the money deposited. Term lengths for CDs vary and can be relatively short (a month) or long (ten years). Typically, the longer the length of time before the maturity date, the higher the interest rate. Withdrawing funds prior to the term date often results in a penalty fee. There are CD accounts that do not have this penalty and allow your money to be more liquid, but they also come with lower rates of return. CDs are a good strategy for saving money if you have a good idea of the date you will reach your goal and you don’t need to access the money in the interim. This account type can act as a safe guard of sorts so that you don’t spend the money on something other than your goal. However, if you need your funds to be more liquid, the accounts mentioned above are likely better fits.
The final option (or group of options) available are investment accounts. These accounts can be comprised of stocks, bonds, exchange trade funds, and mutual funds. If money in these accounts is accessed within a year of deposit, gains will be taxed at the account holder’s ordinary income tax rate. If funds are left to mature longer than one-year capital gains tax rates will apply at withdrawal. These accounts are good for long-term goals like retirement saving or saving for college. The type of investments made, and the asset allocation of these accounts depends on the time horizon of the goal and the risk tolerance of the investor.
One thing that becomes clear as each of these account types are described is that most individuals won’t have just one account to meet all of their savings needs. It is important to pick the account that is best for each individual goal instead of just one savings strategy. Doing so will allow you to maintain liquidity in the short-term while also maximizing your return on investment in the long-run. There is even research that shows that having separate savings vehicles for each goal can result in more effective saving. If you have many short-term goals it can be helpful to break them into separate accounts for each goal. You can read more about this strategy here.