Where you put your retirement savings has a significant effect upon how fast your savings grow and when you can afford to retire. You've probably heard of IRAs and 401(k)s, maybe even the less common 403(b)s or self-employed retirement accounts, but what about a bank account?
It's a popular choice, with 66% of workers who save for retirement outside of work using one of these accounts, according to a Transamerica survey. But keeping your retirement savings in a bank account could actually hurt you in the long run. Here's why.
Bank accounts: The good and the bad
There are pros and cons to stashing your retirement savings in a bank account.
When you put money into a bank account -- whether it be a checking account, savings account, or certificate of deposit (CD) -- you don't have to worry about losing it due to daily market fluctuations. Your balance will only increase over time.
This security is a huge plus, especially for retirees and those approaching retirement who are worried about a possible market crash wiping out their savings. In this case, moving money for their near-term expenses into a bank account could be a smart move.
Bank accounts will never give you the high returns you can get from the stock market. Even the best savings accounts and CDs offer about 0.50% APY. If you put $10,000 in a savings account that earned 0.50% over 10 years, you'd only have $10,511. Had you invested that $10,000 in the stock market where it earned a 7% average annual rate of return, you could've had close to $19,672 by the end of 10 years. The difference in returns between the two accounts only grows over time.
Because your money won't grow as quickly in a bank account, you must contribute more money per month to retire when you want to. This could delay retirement for some because they aren't able to count upon large investment returns to help them.
People who stash a lot of retirement savings in a bank account could also run into problems with the FDIC insurance limits. A bank account only carries FDIC insurance up to $250,000 per person per account type. If you keep more than $250,000 in a bank account and the bank fails, you could lose the extra.
Better alternatives for your retirement savings
If you'd like to save for retirement outside of work, a bank account probably isn't your best option unless you're very close to retirement. Even then, you should only keep money you anticipate spending in the next year or two in a bank account. Leave the rest invested for now.
You can keep your money in either a traditional or Roth IRA, which you can open with any broker, a taxable brokerage account, or a health savings account (HSA) if you have access to one. Each has its pros and cons.
IRAs offer a lot of investment options and they can be pretty affordable, but you can only contribute up to $6,000 to an IRA in 2021, or $7,000 if you're 50 or older. You must also have earned income during the year or be married to someone who has to contribute to one of these, and you typically can't withdraw your funds before age 59 1/2 without penalty.
Taxable brokerage accounts
Taxable brokerage accounts aren't retirement accounts, so they don't offer the same tax breaks that retirement accounts do. But there are also no limitations on what you can invest in or how much you can contribute each year. You're also free to withdraw your money whenever you see fit. But for most people, it makes sense to hold your savings for at least one year. Then, your earnings are subject to long-term capital gains tax instead of short-term capital gains tax. This can help you save money.
Health savings accounts (HSAs)
Health savings accounts also aren't retirement accounts, but they serve the function anyway. They're open to anyone with a health insurance plan that has a deductible of $1,400 or more for an individual in 2021, or $2,800 or more for a family. Contributions reduce your taxable income for the year, and if you use the money for healthcare at any age, it's tax-free.
You can also make non-medical withdrawals, though you'll pay taxes on these plus a 20% penalty if you're under 65. Individuals may contribute up to $3,600 to an HSA in 2021, and families may contribute up to $7,200. Some HSAs enable you to invest your contributions so they can grow more quickly.
Protecting your investment
Deciding where to put your savings is only half the battle. Once you choose an account, you also have to decide what to invest in. It's important to make sure you're not exposing yourself to too much risk, but you also don't want to be too conservative or you'll make your job harder. A good rule of thumb is to keep 110 minus your age in stocks. That means you'd invest about 70% of your savings in stocks if you were 40 and the remaining 30% in bonds. Over time, you move more of your savings into bonds to protect what you have.
You also want to make sure you're choosing wise investments, preferably ones that have low fees. An index fund is a great option for most investors. This is a bundle of stocks you purchase together and it's designed to match the performance of its underlying market index, like the S&P 500. Consider adding one of these to your portfolio if you haven't already.
Make sure you review your retirement strategy at least once per year. The best investments and the best retirement accounts for you will likely change over time. Understanding all the options available to you will help you make the right call.