Savings Accounts vs. IRAs: Which is Better?
Savings accounts and individual retirement accounts (IRAs) are both commonly used to build savings. However, they are very different and each has its own strengths and weaknesses. Put simply, savings accounts are ideal for short- to medium-term savings. IRAs are better for long-term savings that you intend to use during retirement.
In this article, we go over the core concepts of both accounts to help you choose the right one.
Quick answer: Use both types of accounts -- not one or the other. Savings accounts are ideal for emergency funds and short-term financial goals. IRAs are designed for building savings for retirement.
How Savings Accounts Can Help You Build Savings
A savings account is one of the most common bank accounts. It’s the type of account that your parents might have helped you open when you were a kid. The point of a savings account is to serve as a place where you can keep money and earn some interest on it.
When you deposit money in a savings account, the bank guarantees that when you ask to withdraw it, they’ll have it waiting for you. Even if the bank goes under, the Federal Deposit Insurance Corporation (FDIC) insures savings accounts up to $250,000. No matter what, you’ll always be able to get your money back.
Banks use the money in deposit accounts to offer loans to other customers. Essentially, you are making a loan to the bank, but you can ask to be repaid at any time. In return, the bank offers interest on the amount that you have deposited.
Earn interest on your savings
The interest that the bank offered is expressed as a percentage of the money you have deposited. For example, a savings account might offer 1.00% APY (annual percentage yield) each year. That means that for every $100 you keep in the account for a full year, you’ll earn $1. Interest is typically paid each month, so you aren’t forced to keep your money in the account for a full year.
Because there is no risk of losing the money you’ve put in a savings account, the returns tend to be low. Much lower than stocks, bonds, or other investments. Savings accounts are intended to be a way to keep money that you absolutely cannot afford to lose. They’re also well suited for storing money that you plan to use soon since you cannot lose the money.
How IRAs Focus on Retirement Savings
An IRA is a type of retirement savings account that lets you save money that you plan to use when you retire. There are many types of IRAs, including IRAs specifically for small business owners, but the most common types of IRAs are the Roth and traditional IRAs.
Unlike the other retirement account that most Americans are familiar with, the 401(k), IRAs are available to anyone. Your employer does not need to offer one as a benefit.
Basics of a traditional IRA
Traditional IRAs are very flexible and come with some major benefits. They have one main drawback: that you cannot withdraw money in an IRA until you turn 59½ without paying a penalty. In some cases, there are ways around that rule, so proper planning is important when making use of IRAs.
The biggest benefit of a traditional IRA is that they are, subject to some restrictions, tax-deductible. That means that any money you contribute to the IRA is subtracted from the income you report to the IRS. If you made $50,000 last year and contributed $5,000 to a traditional IRA, then you can tell the IRS you only made $45,000. Every $1,000 you contribute to an IRA costs you as little as $750, or less depending on your income, thanks to the tax break.
In exchange for not paying tax on your contributions up front, you must pay tax when you make withdrawals from your IRA. Most people make less money in retirement than they do while they are working. That puts them in a lower tax bracket, meaning less tax being paid overall.
IRA contribution rules
To qualify for the tax breaks that an IRA offers, you need to make less than $62,000 per year if you’re single, and $99,000 if you’re married. Above that amount, you get only a partial tax break or no tax break at all.
If you are on the other end of the income spectrum, you get more tax incentives for saving in an IRA. The Saver’s Credit will pay anyone whose income is under a certain amount if they contribute to a retirement account.
If your income is:
- Less than $18,500, you’ll get a tax credit of 50% of your contribution, up to the first $2,000 you contribute.
- Between $18,500 and $20,000, you’ll get a 20% credit.
- Between $20,000 and $31,000, you’ll earn a 10% credit.
Married people filing jointly can get credits on up to $4,000 in contributions, with income limits that are double that of a single person.
Reduce your taxable income
Your income is checked against those limits after you make your deductions for retirement contributions. That means even if you make $35,000 a year if you contribute $5,000 you’ll only report $5,000 in income, allowing you to qualify for the credit.
You also don’t pay tax on dividends, interest, or capital gains in the account until you withdraw the money. That makes IRAs great for tax inefficient investments, like bonds or real estate investment trusts.
The other benefit of IRAs when compared to employer-sponsored retirement accounts like 401(k)s is choice. In employer-sponsored plans, you can only invest your money in the options chosen by your employer. You can invest your IRA in anything. You can put the money in a savings account, stocks, bonds, even real estate. You have full control over the money you place in an IRA.
As of 2017, each year you can put up to $5,500 into an IRA. If you’re 50 or older, you can add an extra $1,000. The amount you can contribute each year changes with inflation, so the limits will rise over time. If you don’t use all the contribution space each year, it’s gone, so taking full advantage is important.
The government has tried to make it easier to use all the space. You can make multiple smaller contributions over the course of the year until you hit the cap. That way you don’t have to come up with thousands of dollars all at once. You also have until your taxes are due to contribute to that year’s IRA. That means that you can contribute to your 2017 IRA until April 17th, 2018, giving you a bit more than a full year to max out the account.
Where Do They Fit in Your Savings Strategy?
Because IRAs and savings accounts are very different, they serve very different roles in your savings strategy.
IRAs for your nest egg
IRAs are designed to be used for retirement savings. The tax incentives and flexibility you have to invest the money in an IRA make them perfect for the purpose. That means that IRAs are ideally suited for volatile investments that are expected to do well in the long term.
Once you’ve gotten closer to retirement age and want to tone down on the risk in your investments, you can still make use of IRAs. Most people’s income increases as they age, amplifying the tax savings benefit that IRAs provide. Since you can invest the money in an IRA anyway you’d like, you can put the money in low-risk investments as you get closer to retiring. That lets you keep your nest egg safe while still getting the tax benefits.
Savings for risk-free growth
Savings accounts, by contrast, are easy to access and incredibly safe. That makes them perfectly suited for storing money that you’ll need sometime soon. They’re also intended for money that you absolutely cannot afford to lose. If you have a big purchase, like a new car or holiday gifts coming up, a savings account is the way to go.
Savings accounts should also be used to hold your emergency fund. Though most Americans have less than $1,000 I a savings account, everyone knows that unexpected expenses can come out of nowhere.
Keeping some money in a savings account to deal with the unexpected can help you avoid credit card debt. Even if the return you earn on a savings account is lower than what you could earn if you invested in an IRA, avoiding credit card debt is essential to your financial health.
Use Savings Accounts and IRAs Together
Savings accounts and IRA are both powerful parts of your financial toolkit. One helps you prepare for retirement, even if it’s years down the road. The other helps you prepare for more immediate spending needs. Making sure that you take full advantage of both types accounts, and know how to use them, is important for keeping your finances healthy.