In most cases, the purpose of a savings account is not clear to me. Below I propose a basic structure for the flow of money in your life:
- Money comes from your employer and lands in an account–probably a checking account.
- A portion of this money is used to pay for your expenses. If you track your expenses, this amount will be known to you. Otherwise, your method will be less precise.
- The amount of money needed to cover expenses, plus whatever extra cushion you like to keep just in case1I prefer ~$1k, or slightly less, will remain in your checking account, the place from which all bills will be paid.
- The remainder of the money will be invested, either in a retirement account (preferably, if available) or a taxable brokerage.
- The next time you get paid, go to step 1 and repeat.
This general formula will work for the majority of your working life. At most, it requires a checking account, work retirement account, IRA, and a taxable brokerage account.
But what if you are SAVING for something?
After all, savings accounts are generally thought to be for savings. This really depends on your time horizon. If you’re saving for something in several years, like retirement, well there are better ways to do that than barely keeping up for inflation in a savings account. But what about something in the next few years, like maybe a down payment for a house? While some would consider this aggressive, I would recommend still investing that money, but using an asset allocation that will greatly smooth the ride while still providing significant returns. For example, you could go with a 50/50 stock/bond allocation.
This can be done in a regular brokerage account OR, better yet, in a Roth IRA. Generally considered by prestigious financial blogs to be inferior to Traditional IRAs, Roth IRAs do have some key features that make them useful in certain situations. One of these is the ability to take out principal2the amount you put in at any time without penalty. If you’re saving specifically for a first-time home purchase, you can also take out up to $10,000 of interest, making the Roth IRA even more superior to the savings account if you’re saving for a down payment.
Of course, if you just want a separate account for money you don’t want to touch and use to buy a car in 6 months, a savings account isn’t a bad idea. Use it if it helps you, but first consider the other options.
What about emergency funds?
What about them?! I prefer to use a 5 year CD, which generally provides higher interest than a savings account and can easily be terminated for an insignificant fee in case of emergency. As previous discussed though, emergencies are pretty rare, and once your stash is really starting to build up the need for a separate emergency fund diminishes rapidly. Some people choose to go without one altogether.
There is a time and place for savings accounts. But if you can simply your financial life with one less account, or optimize it by using a different type of account, why not do that? A conservative investment strategy within a brokerage account or Roth IRA is an effective way to save for short- or medium-term expenses.