A savings account gives you a safe, accessible place to put money that you don’t need for daily expenses. It also pays you interest, so you can earn a little money on top of what you have put in your account.
In this article, I’ll help you understand what savings accounts are, why they exist and how you can make them part of your financial life.
Table of Contents
- What Is a Savings Account?
- How Savings Accounts Work
- The Advantages and Disadvantages of Savings Accounts
- Why You Need a Savings Account
- What the Best Savings Accounts Have in Common
- Frequently Asked Questions About Savings Accounts
What Is a Savings Account?
A savings account is a product that banks and credit unions offer to customers and members who want to store money safely and earn interest.
If you’re new to banking, that may sound too good to be true. But keep reading. I’ll explain how banks can keep your money safe at no cost to you and instead, allow you easy access to your funds and pay you for the privilege of doing so.
Other financial tools can earn you more money, but they’re often riskier and less liquid than savings accounts. For example, you could invest in the stock market, but the price of the stock you buy could go up or down, and you could face tax penalties depending on when you sell.
A savings account isn’t the most accessible place to keep your cash, but you’ll earn interest on your money, and it’s still pretty easy to get to. Because of inflation, which causes the purchasing power of the dollar to decline over time, leaving all your money in your wallet or under your mattress actually costs you.
It’s important to note that the interest rates your money earns in savings accounts tend to be variable rather than fixed. They can go up or down.
Putting your extra money in a savings account is a great way to keep it separate from what you use for your daily spending. For that, you could use a checking account.
A savings account tends to function best as a tool to help you meet monetary goals, like paying for your honeymoon or making a down payment on a car. You can also use them to sock away cash for short-term needs or emergencies.
How Savings Accounts Work
If you want to open a savings account, you’ll apply at a bank or credit union, and at some point, you’ll put money into your account.
The bank will take the money you gave it and loan it to other customers.
You may be thinking, ‘How is that legal? Isn’t the point of savings accounts to, you know, save?’ But banks need your money to operate. They take money from you and pay you interest. Then they lend it to someone else and charge them more interest than they pay you. That’s how banks work.
If in the unlikely event that your bank vanishes into thin air, or every customer asks to take out their money at the same time, or a family of large sewer rats gets into the vault and chews up all the cash, your money is still safe.
The Federal Deposit Insurance Corporation (FDIC) protects individual accounts up to $250,000. The FDIC was created by the United States government to protect consumers in case a bank fails.
Almost all banks and credit unions offer at least one kind of savings account, and many offer more than one. So do some brokerage firms, which are better known for giving you access to the stock market.
The Advantages and Disadvantages of Savings Accounts
Like most everything in life, there are pros and cons to savings accounts.
Savings accounts offer you:
- Safety. As long as your bank is FDIC insured, the money in your account is safe up to $250,000. No tornado, fire, bank robbery or bad business deal can jeopardize it.
- Interest and accessibility. Savings accounts put your money to work for you. Although they may not earn you a great return, especially in 2020 with interest rates at low levels, you can spend or take out the money easily and usually without penalties.
- Technology to help you save. The best accounts provide software that allows you to set multiple specific savings goals and track your progress. They often provide ways for you to move or allocate money automatically to make saving easier.
- A way to keep your money from burning a hole in your pocket. You see ads on TV, on social media, in stores and other places every day, even in this article. You are bombarded with people trying to separate you from your cash. But savings accounts can ensure that you are thinking on a longer time horizon than today, this week or this month. Keeping some money in a place that’s not your wallet or your checking account is a good idea for most people.
- Don’t maximize your earnings. In almost every case, there are better ways to earn a return on your money than a savings account, especially if your timeline is long enough and you won’t need quick access to your funds.
- Give you access that could be too easy. Liquidity can be a good thing. But it can also be a disadvantage, as the ability to easily access the money you’ve saved for specific goals could tempt you into spending it. It’s harder to get cash in your hand by selling a stock, for example, than it is to just take money out of your savings account.
Why You Need a Savings Account
When I was a kid, I loved buying baseball cards. I knew how much they cost, and I knew I couldn’t get any new baseball cards unless I had enough money.
My parents paid me a weekly allowance if I did all my chores. I’d keep all the money they gave me in a Velcro wallet (I know, a piggybank would sound cooler). When I had saved enough money, I’d go to the baseball card store.
Unfortunately, once you get older, you’ll start facing expenses that are not as fun as your childhood hobby — and sometimes much less predictable.
You may need to pay for vehicle repairs, medical costs or college tuition. Things break, people get sick and jobs don’t last forever. It’s a good idea to have some money saved to pay for things you can’t anticipate. But some expenses are fun, even if the price tag may not be. Think of things like family vacations, car down payments and Christmas presents.
Clark thinks savings should begin with setting specific goals and then figuring out how much money to put toward those goals from every paycheck.
“If somebody has a target they’re trying to reach, they’re much more likely to get it than if it’s just a wishy-washy thing of, ‘Well, I need to save some money right now, because everybody says you should have some money saved,'” Clark said.
What the Best Savings Accounts Have in Common
I go into detail in my story on the 7 best savings accounts in 2020, but in my opinion, the most important attributes of a good savings account are strong interest rates and a lack of fees. Here’s more about the qualities you should look for:
- No fees or requirements. The best savings accounts do not charge you a monthly maintenance fee, don’t require a minimum deposit amount and don’t require a minimum monthly balance.
- Competitive interest rates. There’s not much you can do to change the national trend: Interest rates have been extremely low for several years now. But you can pick a financial institution that offers relatively higher rates and consistently beats the competition.
- Goal-savings software. You want a bank that makes it easy for you to work toward multiple savings goals at once. Some banks allow you to separate your funds toward multiple goals. The $1,000 you have saved for the family vacation can exist in a different “bucket” inside your savings account than the $1,000 you have put aside for car maintenance.
- Strong website and app. Banking is becoming more and more digital by the year. Some banks are online-only, and even if your bank has physical locations, chances are you’ll use the website or app frequently. so you want your bank’s app to function well and be easy to use.
Want more detail? Check out my story on the 7 best savings accounts in 2020.
Frequently Asked Questions About Savings Accounts
How Do I Calculate How Much Interest I’ll Earn?
If you’ve ever read about savings accounts on bank websites, you’ve probably noticed that interest rates are expressed by APY, or Annual Percentage Yield.
Banks pay interest at different intervals. Some pay daily, some pay monthly and some pay quarterly. APY normalizes each bank’s interest rate for a 12-month period. So, even though banks pay interest at different times, APY allows for an apples-to-apples comparison.
To calculate how much interest you’ll earn in one year, multiply the amount of money in your savings account by the APY.
Do I Have to Pay Taxes on the Interest I Get From My Savings Account?
Yes. The Internal Revenue Service (IRS) considers money that you earn in the form of interest to be taxable income.
Savings account interest gets taxed at the marginal tax rate, which is a fancy way of saying that whatever income tax bracket you fit into applies to the money you make on interest.
Your bank or financial institution will send you tax form 1099-INT if you earn more than $10 in interest in a year. But the IRS requires you to report all of your interest income, even if it’s less than a dollar.
What Is a High-Yield Savings Account?
A high-yield savings account simply pays interest at a rate many times higher than the national average for traditional savings accounts.
High-yield accounts also typically come with no fees and few requirements.
Because these accounts offer more competitive interest rates, they tend to change their rates more frequently.
Several factors influence how often banks change their interest rates, including whether they’re running promotions to attract more deposits, whether the Federal Reserve is raising or lowering rates and how much demand there is for bank loans and U.S. Treasury notes.
How Do Savings Accounts Compare to Similar Banking Options?
Savings accounts are not the only financial products that pay interest. Some checking accounts pay interest.
And there are others. The following financial tools also pay you to hold your money but usually don’t have the combination of accessibility and competitive interest rates of the best savings accounts.
Money Market Accounts: They come with checkbooks and debit cards, but also pay you interest — sometimes at a higher rate than savings accounts. But they typically require you to keep a minimum balance.
Certificates of Deposit (CDs): You agree to leave your money in the account for a set period of time in exchange for a fixed interest rate that may be higher than what your money would earn in a savings account. There are penalties if you take your money out early.
Cash Management Accounts: They take features of brokerage, checking and savings accounts and roll them into one product. Unlike other interest-earning accounts, they can facilitate investing in the stock market. They usually offer interest rates that are better than traditional banks, and they often let you write checks and make mobile deposits.
Do Savings Accounts Have Monthly Transaction Limits?
Federal Reserve Board Regulation D used to limit you to a maximum of six transactions during a single statement cycle (one month), excluding ATM and in-person withdrawals.
The Federal Reserve changed the rule in April 2020. Banks are now allowed to decide their own transaction limits. Some banks have not lifted the six-transaction monthly limit, while some now allow unlimited transactions.
Savings accounts can be a helpful part of your financial life.
It’s important to set aside money for emergencies and irregular expenses if you can. It’s also nice to earn some money while you keep your funds in a safe, insured place.
Whether you are opening your first account or you already have one, Clark says it’s a good idea to comparison shop occasionally for the best interest rates. Clark recommends using Bankrate’s search tool.
Savings accounts are not the best possible way to make money. They shouldn’t be the only place you put the money you don’t need for everyday expenses. But they’re ideal for some specific goals.