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People save for various reasons such as for big purchases including homes and new cars. Also, saving can help prepare for things in the future such as college tuition, marriages, vacations, or retirement. Whatever the reason for saving, not planning for these events beforehand can result in poor financial outcomes. However, determining exactly how much to stash away each year or month in savings can be difficult.
Savings Accounts
In U.S., savings accounts are bank accounts insured by the Federal Deposit Insurance Corporation (FDIC) with the ability to earn interest on deposited funds (savings). They can be opened at most banks, credit unions, or other financial institutions, but will vary in traits such as synergy with checking accounts of the same institution, annual percentage yield (APY), and minimum balance requirements. Regarding the first, financial institutions generally offer incentives, such as waiving monthly fees, for opening savings and checking accounts.
While savings accounts are often linked to checking accounts, there are some key differences. Checking accounts are deposit accounts through financial institutions that allows the withdrawal or depositing of funds. They are highly liquid and, for the most part, funds can be withdrawn without penalties. Also, they tend not to pay interest, and those that do, have some of the lowest interest rates. On the other hand, savings accounts have limitations on withdrawals and may require maintenance of a minimum balance in order to avoid penalties.
A key characteristic of savings accounts is their ability to earn interest at rates generally higher than those offered by checking accounts. However, a major drawback is that a federal limit in the U.S. only allows for no more than six outgoing transactions (withdrawals) a month. Due to this, savings accounts are most useful as a means to store funds that a person does not immediately require, such as savings or emergency funds. Although savings accounts are not as liquid as checking accounts, it is still one of their beneficial aspects. When compared to the relative liquidity of cashing bonds, withdrawing from retirement accounts, or selling stocks or other assets, savings accounts are much easier to access when cash is needed.
It can be a good idea to have both at the same time; a checking account can be used to store cash for immediate needs for everyday purchases using a debit card, and a secondary savings account can be used to hold any excess cash that can earn interest in the meantime. With that said, savings accounts aren't the only way to save and earn passive income. There are alternative investments with similar risk levels that can offer higher returns such as Certificates of Deposit (CD) and Treasury bills. Investors with excess funds who want to stretch their dollars may also want to explore other passive income options.
Money Market Accounts
Another form of savings account, called money market accounts (MMA), are also available through many financial institutions. MMAs generally earn interest at rates greater than savings accounts because deposits are invested into securities rather than loans or assets earning low interest. Due to this, MMAs are exposed to risks associated with financial markets. Certain MMAs may also offer ATM and debit card services, which are generally not associated with traditional savings accounts. Accounts with such features may come with lower interest rates.
Contributions
When deciding how much to contribute towards savings accounts, there are several general guidelines that can help:
- Emergency Fund Rule—Have enough in savings to cover at least three to six months' worth of living expenses, which can also double as insurance for emergency spending such as medical bills. In the case of sudden unemployment, there is enough in savings to draw from for a lengthy period long enough for the chance to find new employment.
- 10% Rule—Set aside 10% of each paycheck to place into savings.
- 50-30-20 Rule—This rule states that 50% of income should go towards necessities like house/rent, food, and bills, 30% should be allocated for luxuries like dining and entertainment, while the last 20% should go towards paying off debt or savings.
- The Federal Reserve Bank determined that the average amount a consumer needs to resolve emergencies is about $2,000. This may be a good figure for some to aim for.
While they are helpful, there are simply too many varying factors to consider for each individual, such as how much they currently have in savings, how much they make relative to how much they spend, the future forecast of their short and long-term spending, among other things. As a result, these guidelines should be taken with a grain of salt.
Saving Too Much?
There are generally no limits as to how much can be deposited into savings accounts, just keep in mind that for any accounts within the same financial institutions, only amounts that are $250,000 or less are insured by the FDIC. However, just because there is no limit to how much savings accounts can be funded does not mean that it is a good idea to perpetually do so. This is due to several reasons. The first is that many other opportunity costs exist to earn passive income. Investment in stocks, bonds, or real estate are good examples, and generally offer higher return rates than savings accounts at the sacrifice of liquidity. The second is that, given inflation in the U.S. is historically 3%, average savings account returns of 1% or even 2% will not preserve the purchasing power of money, let alone earn income. If liquid savings accounts are generously funded and excess cash still remains, it may be worthwhile to look to other investment options that offer greater returns.