Savings Account vs. Roth IRA: Which is Better?
Savings accounts and Roth IRAs are two common accounts that people use to build savings. However, each type of account is very different and come with its own strengths and weaknesses.
Savings accounts are incredibly safe. That makes them great for short- to medium-term investments, or money you can’t afford to lose. Roth IRAs are intended to be used for retirement savings, and rules restrict withdrawals if you are under 59½ years old. That makes them ideal for riskier, long-term investments.
Quick answer: Neither account is better than the other because the serve different purpose. Therefore, it would be wise to use both accounts as part of your savings strategy.In this article, we’ll go over the pros and cons of each type of account, and where they fit in your savings strategy.
How Savings Accounts Offers Low-Risk Savings
You can open a savings account at any bank in the United States, whether it be a small local bank or national chain. It’s also one of the most common types of bank account. If your parents helped you set up a bank account when you were a child, it was probably a savings account.
Deposits are insured
Savings accounts serve as a safe location for you to keep money, rather than holding it as cash in your wallet or in your home. When you deposit money in a savings account, the bank promises that you can ask for it back, and it will be there waiting for you.
Even if the bank goes out of businesses, you can get your money back thanks to the Federal Deposit Insurance Corporation (FDIC). The FDIC insures up to $250,000 in your savings account, making it impossible to lose the money you’ve deposited.
Earn interest on your money
In addition, banks will pay you interest on the money you keep in a savings account.
For example, if a bank offers 1% interest and you have $1,000 in the account, the bank will give you $10 in interest each year. The bank pays this interest because the deposits that you make are essentially loans to the bank.
The bank takes money that people have deposited and loans it to other customers. That lets the bank offer car loans or mortgages to its customers.
Banks must keep a certain amount of money on hand, depending on how many deposits it has accepted. That means that you can always get your money back when you ask for it.
The interest rate on savings accounts tends to be very low, much lower than other types of investments. This is because there is absolutely no risk to the money in the account, and you can get the money whenever you’d like. Despite the low returns, those features make savings accounts perfect for short term saving.
They’re also well suited for storing money that you want to set aside for unexpected expenses or that you cannot afford to lose.
How Roth IRAs Focus on Long-Term Growth
Individual Retirement Accounts, (IRAs) are special, tax-advantaged accounts that are designed to help people save for retirement. There are many types of IRA, including IRAs specifically for people involved with small businesses. The most common types of IRAs are the Traditional and Roth IRAs. Roth IRAs are a specific type of IRA that offer unique tax benefits to people who use them.
Unlike 401(k)s, the most familiar retirement account to most Americans, Roth IRAs can be opened by anyone. Your employer does not need to offer access to a Roth IRA as a benefit.
Roth IRAs are very flexible in that you can invest the money in them in any kind of financial instrument. You can use a Roth IRA to invest in stocks, bonds, futures, options, or real estate. There is one main drawback to using a Roth IRA: you cannot withdraw earnings on your investment until you turn 59½. This differs from Traditional IRAs, which restricts withdrawals on all money in the IRA until you reach 59½. Roth IRAs allow you to withdraw invested principal at any time.
No taxes when you take out your money
The main reason to put your money in a Roth IRA is the tax benefits that the account provides. Normally, when you invest money, you owe taxes on the money your investment earns. Whether you get your returns as dividends or capital gains, the IRS gets a cut.
When you put money in a Roth IRA, you never pay tax on it or its earnings ever again. The IRS allows this because unlike traditional retirement accounts, you do not get to deduct contributions on your taxes.
Because you pay taxes on money you contribute to a Roth IRA you need to think carefully about the decision. By contributing to a traditional IRA, you get immediate tax savings. If you’re in the higher tax brackets, that savings can be 20 to 30%. Many people end up having less income in retirement, putting themselves in a lower tax bracket than when they were working. That makes the upfront tax savings more valuable.
Who should open Roth IRAs
Roth IRAs are best for people who expect to be in a higher tax bracket when they retire than at the time of contribution. Generally, that means that people in the 10 or 15% tax brackets (up to $37,950 for singles or $75,900 for married filing jointly) should consider a Roth IRA.
If you are in a lower tax bracket, you can still get some money off your tax bill by contributing to a Roth IRA. Though you can’t deduct the contribution, you may qualify for the saver’s credit. If your taxable income is less than $31,000, you qualify for the credit. The saver’s credit pays 50, 20, or 10% of your retirement account contributions back to you as a tax credit. The credit only applies to the first $2,000 you contribute, so you’re limited to getting $1,000, $400, or $200 from the credit. Still, taking advantage of the saver’s credit can augment the benefits of using a Roth IRA.
If you’re in a higher tax bracket but still want to contribute to a Roth IRA, you’ll need to pay attention to the income limits. If you are single and make more than $117,000, you cannot contribute the maximum to your Roth IRA. If you make more than $132,000, you can’t contribute at all. For couples, the phase out begins at $184,000 and contributions are fully disallowed at $194,000.
Assuming your income does not disqualify you, you may contribute up to $5,500 to IRAs each year. This limit is shared between all your IRAs, so you can’t contribute $5,500 to a Roth IRA and $5,500 to a traditional IRA. If you are over the age of 50, you can add an extra $1,000 each year. You have until Tax Day of the following year to make IRA contributions, giving you a bit over 15 months, to fund the account.
How They Fit in Your Savings Strategy
Roth IRAs and Savings accounts are incredibly different ways to save money, but both are powerful tools that you should use.
Roth IRAs are designed for retirement savings. If you’re young, that means you won’t need the money you put into a Roth IRA for a long time. That gives you the freedom to put the money in your Roth IRA into volatile investments are expected to do well in the long term.
If you have forty years until you plan to retire, a diversified investment portfolio can help you build your nest egg. Doing so in a Roth IRA lets you minimize the taxes you pay on your investments.
You can also use Roth IRAs to shelter tax inefficient investments, such as dividend-paying stocks. Because you don’t pay tax on money in the account, you won’t have to worry about paying tax on the dividends.
Savings accounts should be used for your short-term savings needs. If you’re hoping to make a purchase in the near future, a savings account is the place to put the money you plan to use. Because you can never lose money that you put in a savings account, you don’t have to worry about losing progress towards your goal.
That safety also makes a savings account the perfect place to keep an emergency fund. Unexpected expenses can pop up at any time. Keeping money in a savings account to deal with getting laid off, a medical bill, or broken down car can help you avoid debt. Even though you’ll earn a nominal return on the money you have in a savings account, avoiding debt is essential to your financial health.
Both Accounts Are Important
Roth IRAs and savings accounts are two very different but very powerful financial tools. One is helpful for preparing for retirement while the other is great for housing money you can’t afford to lose. Taking full advantage of both and knowing how to use them will put you on the path to financial success.