If there's anything the current economic recession has taught us all, it's that saving for an unexpected emergency is critical. But it's easier said than done, and deciphering all of the savings account options out there is enough to make your head spin.
Whether you're looking to build up six months' worth of income or are saving for a big purchase (like your first home), investing your cash in the right type of account is critical if you want to make your money go the distance.
To help you get a jumpstart on your finances, TMRW consulted industry experts to break down four of the most common savings accounts. Now all that's left to do is determine which one is right for you.
Traditional Savings Account
What is it? Similar to checking accounts, this basic account is a pretty common option and you likely already have some money stored away in one. Traditional savings accounts can be used for both short-term and long-term savings and pay interest on the money you deposit.
What are the pros? A traditional savings account is a relatively safe space to store your money and is a pretty accessible option for the majority of savers. "Savings accounts are easy to open and your money is easily accessible. They accrue interest, you don't need to start with a large amount, and your savings are FDIC insured," WalletHub analyst Jill Gonzalez said.
It's also a good idea to save up an emergency fund in one of these accounts that will be instantly accessible to you in case you ever need it.
What are the cons? If you're hoping to make a nice return on your investment with a traditional savings account, don't hold your breath. These accounts typically offer a pretty low interest rate, with the national average ringing in at a mere 0.06% according to Scott Henderson, financial coach and member of the Association for Financial Counseling and Planning.
"Although the peace of mind of having your money in a savings account is nice, you run a risk of leaving it there. That risk is called purchasing power risk," Henderson said. "One hundred dollars today will buy you less in 10 years because of inflation, so if you’re not earning at least enough interest to keep up with inflation, the value of your dollar decreases over time."
Certificate of Deposit (CD)
What is it? Similar to a traditional savings account, a certificate of deposit accrues interest on an amount that you deposit and is FDIC insured. However, CDs grow at a locked-in interest rate/annual percentage yield (APY) and you can't withdraw them over a set period of time (unless you want to incur a penalty).
What are the pros? If you've been building your savings for a while and are ready to get more bang for your buck with a higher interest rate, CDs are a good option. "CDs are great for anyone who won't touch their money for 1-5 years, doesn't want to lose any money, and is trying to keep up with inflation," Henderson said.
The great thing about CDs is that they're low risk and have a fixed, guaranteed interest rate that can help you save for investments, like a down payment on your dream home.
"Something that seems to be effective with CDs is called a CD ladder. For example, you open multiple CDs to have access to your money at different times in the future without locking all of your money into one long-term account. Then you’re able to access certain amounts at different times because your CDs are maturing," Henderson said.
What are the cons? You can't withdraw your money from a CD until its maturity date, so depending on how much other money you have access to and how much you might need in case of an emergency, tying your money up for a fixed period of time may or may not be a practical option.
“If you think you’ll need the money you’re saving before the end of a CD term, you’ll want to try another investment method," said Jennifer Ruiz, Sallie Mae director of corporate communications.
CD rates are tied to national interest rates, and they tend to take a nosedive during rough economic periods, so now isn't a great time to open one. Another downside? You'll have to pay taxes on any accrued interest.
Individual Retirement Account (IRA)
What is it? Looking ahead to retirement? An individual retirement account could be right for you. There are two types of IRAs — traditional and Roth — and they allow you to save either with tax-free growth or on a tax-deferred basis.
What are the pros? Storing money in an IRA now can help you accrue some nice interest over the course of your career. “An IRA is a great long-term savings option, especially for anyone who does not receive an employer sponsored 401(k) or other type of retirement account. This will allow you to slowly put money away for your retirement," Ruiz said.
There are also two options, depending on how you'd like to handle taxes in your retirement. Putting money in a traditional IRA account now can help you score a nice deduction on your tax return and your savings will grow with taxes deferred until you withdraw them in retirement.
A Roth IRA, on the other hand, is taxed as ordinary income, but withdrawals are tax-free as long as you meet certain conditions, like holding the account for at least five years and being at least age 59½ when you start distributions instead of 72.
What are the cons? Handling the tax nuances of an IRA can be a bit tricky and it can be hard to predict if you're better off paying taxes on your IRA now or when you retire.
"Imagine you’re a wheat farmer. You plant seeds and harvest the wheat. Would you rather pay taxes on the seed or the harvest? Your decision is solely based on whether you think taxes will be more in the future. You’ll pay tax on the seed now if you think taxes will be higher in the future or pay taxes on the harvest if you think taxes will be lower in the future," Henderson said.
One other disadvantage to IRAs? You'll pay a penalty for early withdrawals.
Money Market (MMA)
What is it? A money market account is a higher interest account that often includes a debit card or check-writing capabilities. It's basically a mix between a checking and savings account and is FDIC insured.
What are the pros? For starters, an MMA offers you easy access to your cash so you don't have to worry about maturity dates or early-withdrawal fees. "Money market accounts are good for people who want to save, but who might need to tap into those savings to cover an emergency or an unexpected expense," Gonzalez said.
Higher interest rates also make MMAs a more high-yielding option than a traditional savings account. "You’ll be able to have a safe place to put your cash for a short period of time and your money will earn a higher interest rate than it would in a checking or savings account,” Ruiz said.
What are the cons? MMAs often require a higher minimum deposit and there are sometimes limits on the number of checks you can write each month, as well as on the amount of cash you can withdraw.
“Make sure you look at minimums and fees before you decide on a money market savings account; money market accounts often need a minimum balance to avoid a monthly service charge," Ruiz said.
The bank can also invest your MMA funds in a different way than they might with a traditional savings account. "With an MMA, the bank may put your money in a CD, low-risk mutual fund or government securities," Henderson said.