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There’s a benefit to putting money into a savings account. Savings accounts are very flexible, allowing you to access your funds whenever you need to. Also, your principal deposits are protected as long as they don’t exceed $250,000 and your bank is FDIC insured. For a joint account, this limit rises to $500,000.
But savings accounts also aren’t perfect, and there are a couple of drawbacks to using one. Here are some pitfalls you might encounter with a savings account — and how to get around them.
Downside No. 1: Your interest rate isn’t set in stone
You might put money into a savings account at a time when its APY is 4.00%. But in four months from now, your account’s APY could fall to 3.50%, which means you’re then earning less interest on your money.
Solution: Open a CD instead
CD rates are set in stone. When you open a CD, you’re guaranteed the interest rate you sign up at for the duration of your CD’s term.
The Federal Reserve is expected to cut interest rates at some point in 2024. Once that happens, the APY on your savings account is likely to drop. You can avoid losing out on interest income by putting your money into a CD. You may, in fact, want to lock in a longer-term CD — say, one with a term of 48 or 60 months — in anticipation of rates falling over the next few years, which may happen given how elevated they are today.
Downside No. 2: Your interest income will result in a tax bill
The interest income you earn in a savings account is taxed as ordinary income, which means it’s taxed at the highest rate you’re subject to based on your marginal tax bracket. If you earn a lot of interest in a savings account this year, you may end up with a smaller tax refund in 2025. You might even have to write the IRS a check.
Solution: Put money into a Roth IRA and invest it
If you’re saving your money for retirement purposes, opening a Roth IRA is a great way to get out of paying taxes on your gains related to that money — in the near term and the long term. Roth IRAs allow you to invest your money in a tax-free manner. You can contribute up to $7,000 this year if you’re under 50, or $8,000 if you’re 50 or older. Roth IRAs have a variety of investment options, including CDs and bonds.
Let’s say you put $5,000 into a Roth IRA this year and it eventually becomes worth $20,000 over time. You won’t have to pay taxes on that $15,000 gain — ever.
Savings accounts are convenient. And they’re the absolute best place for your emergency fund. But if you prefer a savings option with a guaranteed interest rate, a CD could be a better bet. And if you don’t like the idea of having to share your profits with the IRS, then you may want to look at a Roth IRA instead.
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