Losing money isn't a good feeling for anyone, but stashing all your cash in a savings account to avoid the ups and downs of the stock market could actually guarantee a loss. Even high-yield savings accounts usually don't offer annual percentage yields (APYs) that can beat inflation, so what you're earning in interest probably won't outpace the rise in cost-of-living expenses. Here are three better places to consider placing your savings if you hope to retire someday.
1. Your retirement account
A retirement account is the best place for your savings because it offers tax breaks and you could potentially earn a lot more than you would with a savings account. You invest your retirement account funds just like money you place in a taxable brokerage account. This can lead to some volatility over the short term, but over the long term, you will likely see your investments increase in value. These investment earnings help grow your wealth without requiring you to set aside as much of your own money each month.
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Your company's 401(k) is a good place to start if it offers one. You may contribute up to $19,500 to a 401(k) in 2020 and 2021, or $26,000 if you're 50 or older. An IRA is another option if your company doesn't offer a 401(k), but its contribution limits are much lower. You may only set aside up to $6,000 in an IRA in 2020 and 2021, or $7,000 if you're 50 or older.
You may also have to choose whether to use tax-deferred or Roth retirement accounts. Most 401(k)s and traditional IRAs are tax-deferred, which means your contributions reduce your taxable income this year, but you owe taxes on your distributions. These accounts are best if you think you're in a higher tax bracket today than you'll be in once you retire. By delaying taxes until you're in a lower tax bracket, you'll keep more of your savings.
Roth retirement accounts work the other way. You pay taxes on your contributions this year so you don't have to pay taxes on retirement distributions. These accounts are best if you think you're in the same or a lower tax bracket now than you'll be in once you retire.
2. A taxable brokerage account
One of the biggest drawbacks of retirement accounts is that, with a few exceptions, you can't access your money before you're 59 1/2 without paying a penalty. This applies to tax-deferred contributions and earnings as well as Roth retirement account earnings, though you can withdraw your Roth contributions penalty-free as long as they've been in the account for at least five years. But if you want to access your money before then without penalty, a taxable brokerage account may be a better fit than a retirement account.
These are similar to retirement accounts, but they have fewer restrictions. You can contribute as much money as you want to a taxable brokerage account and invest it in whatever you want, whereas many 401(k)s limit your investment options. You can also choose which brokerage you want to work with, giving you more control over what you're paying in fees.
The downside is you don't get the tax breaks you get with retirement accounts. You'll pay taxes on your contributions and your investment earnings. But if you hold on to your investments for a year or more before selling them, they become subject to long-term capital gains tax instead of income tax. Here's a more detailed guide if you'd like to learn more about how this works, but essentially, it means that you'll lose a smaller percentage of your investment earnings than you would if you had to pay income tax on that money.
3. A certificate of deposit
If you don't want to invest in the stock market but want to earn a higher APY than you can with a savings account, a certificate of deposit (CD) is probably your best option. You can open these at any bank or credit union, though credit unions often call them "share certificates" instead of CDs. You place your money into the CD and agree not to touch it for a certain number of months or years, known as the CD term. Then, when the term ends, you get your money plus the interest you've earned. At that point, you can spend it, move in to a savings account, or reinvest in a new CD.
You can withdraw your money from the CD before the end of the CD term, but you'll usually pay a penalty of several months of interest, so it's usually not worth it. You should only put money in a CD if you're pretty confident you won't need to use it until the end of the CD term.
Usually, CDs with longer terms have higher APYs. To take advantage of this, some people employ a strategy called CD laddering. This is where you break your money down into chunks and invest in CDs of differing lengths. You might split $5,000 into five $1,000 shares and invest one share each in a one-year, two-year, three-year, four-year, and a five-year CD. When the one-year CD term ends, you invest it in a new five-year CD to take advantage of the larger APY. This way, you can access some of your money every year and you can take advantage of better rates if they've risen since you opened your last CD.
CD rates have dropped amid the pandemic, like savings account rates. While it'll likely take at least a few years for these rates to recover, you may want to avoid long-term CDs right now. Stick to short- and mid-term CDs of a couple of years or less. This way, you'll have the flexibility to move your money around between banks or CDs to take advantage of better APYs whenever they begin to rise again.
The three account types listed above are all better choices than a savings account for your retirement money, but you don't have to choose just one. You could keep some money in all three if you'd like or just select the one or two that interest you. You can also keep a little cash in your savings account, but you should stash the bulk of your retirement savings elsewhere.
