Saving money is a skill we learn early in life. Children start saving with a piggy bank and then graduate to a savings account, which helps teach them about compound interest. Many people still think of basic savings when putting money away. But as you get older, you want to get a larger return for your savings, so it pays to learn how to diversify your money. There are different types of savings accounts, and each has both advantages and disadvantages.
Diversifying your savings strategy allows you to maximize the return on your savings while minimizing risk. You can use different types of accounts to meet your immediate financial needs and long-term goals, such as retirement. It’s all a matter of understanding the different types of savings options and how to diversify your money.
What are your savings goals?
Before you can choose the right types of savings options, you must understand your goals. We save money for different reasons:
- To create an emergency fund: Having cash on hand in case of an emergency is always a good idea. Experts recommend setting aside anywhere from 3-6 months of living expenses as an emergency fund to handle financial disasters.
- To cover planned expenses: If you are planning a special event or a vacation, then you will need to set aside extra money for expenses.
- To pay for big expenditures: Big-ticket milestones, such as buying a car or a home or paying college tuition, will require extra funds.
- To secure your future: It’s never too early to establish a retirement fund. The sooner you start to save, the more money you will have when you are ready to retire.
These are just a few reasons people save, and to get the maximum return for your savings, it pays to choose the right savings tool. Different options also perform differently depending on current interest rates. Understanding the different types of savings accounts available can help you make the right choice.
What are the different types of savings options?
Banks and credit unions have a variety of savings products. Each one has a different structure and yields different returns. Understanding the differences will help you weigh risks against returns and choose the best option for your savings goals. Here are some of the most popular savings tools:
A savings account is the type of account that is probably most familiar. You deposit your money in a regular savings account, and it accumulates interest for as long as the money remains on deposit. Savings accounts are popular because they offer a guaranteed interest rate, and deposits are insured for up to $250,000 by the Federal Deposit Insurance Corporation for banks and the National Credit Union Administration for credit unions.
Regular savings do tend to have lower rates than other types of accounts, and some savings accounts have fees. However, a savings account gives you easy access to your money and can be ideal for short-term goals or an emergency fund.
High-Interest Checking Accounts
Many choose a checking account that pays interest on deposits. They can function like a savings account with unlimited check writing. Many banks and credit unions pay interest on checking accounts comparable to savings interest rates. High-interest checking accounts, like iQ’s Intelligent Checking, offer the same interest-earning benefits as a savings account, as well as services like a debit card, online bill pay, mobile banking services, overdraft protection, and more. You also can convert extra cash in your checking into different types of savings accounts that yield a higher return.
Money Market Accounts
Money market accounts (MMAs) function like savings accounts but usually pay a higher interest rate and have limited check-writing ability. Some MMAs also offer higher annual percentage yield returns for larger deposits. An MMA can be useful if you want to save and still have access to your savings, but there are a few disadvantages. Some MMAs have fees based on the amount on deposit and the number of withdrawals.
Certificates of Deposit
Certificates of deposit (CDs) use a different approach to savings. They offer higher interest rates in return for a commitment to keep your cash on deposit for a specified time. They also have penalties for early withdrawal.
However, CDs are ideal if you want to be sure to save money, especially for planned spending such as buying a home or paying for college tuition. If you're going to take advantage of CD rates but want more flexibility, consider a CD ladder where you invest in multiple CDs with different maturity dates so you can convert the CD to cash or reinvest as they mature.
Individual Retirement Accounts
Individual retirement accounts (IRAs) were created specifically for long-term investment savings for retirement. Most IRAs are tax deferred, so they can reduce your taxable income. (You don’t pay taxes until you use the money upon retirement.) Many companies offer 401(k) plans with similar savings benefits, but the funds are taken from your paycheck. IRAs are structured for retirement, so there are penalties for withdrawing money before you reach retirement age. There are limits on how much you can contribute to an IRA each year.
There are different types of IRAs. The most common are:
- Traditional IRA: The traditional IRA allows you to save up to $6,000 per year ($7,000 if you’re over age 50) and is tax deductible, reducing your taxable income.
- Roth IRA: A Roth IRA is similar to a traditional IRA but is considered taxable rather than tax deferred. With a Roth IRA, you pay the tax now rather than when you retire. A Roth IRA may be an attractive option depending on your income and other factors.
- SEP IRA: Designed to serve as a self-employment pension plan, a Simple Employee Pension (SEP) IRA is similar to a traditional IRA, although the contribution limits are higher at $14,000.
- SIMPLE IRA: A Savings Incentive Match Plan for Employees (SIMPLE) IRA is also for self-employed professionals and small businesses. It follows the same rules as a traditional IRA and requires the employer to make contributions to employees’ accounts.
IRAs can be an excellent tool for retirement, but they shouldn’t be the only tool. Use IRAs to help diversify your savings.
Investing your money is a great way to get a higher return on your savings. However, when assessing investment options, there is a greater risk since you can lose money as well as earn money. What makes investments attractive is they have historically shown a higher rate of return over time, averaging 10% per year, but returns are never guaranteed. The best way to protect your investments is diversification. It’s best to consult an experienced investment professional about developing an investment strategy.
It starts with your savings account.
The easiest way to start building your savings is with a savings account. Factor savings into your monthly budget. If you have trouble putting money aside, consider using automatic deposits to transfer money from your checking account every month.
Don’t think of your savings as another source of cash to pay your bills. The objective is to leave your savings untouched unless there is an emergency or a planned expenditure. Once you start accumulating savings, you can diversify, moving money into IRAs, CDs, investments, and other savings tools.
Building your savings is the first step in wealth management. As you accumulate more savings, you can put your money to work earning income in different ways. To help you get started building your wealth, download The Ultimate Guide to Simple Savings to get started.