You've done it: you created a budget and stuck to it. Now, you have some extra income each month, but you're not exactly sure where it will do the most good. If that sounds familiar, you're not alone. Many Americans don't save simply because they don't know where to put it.
Don't let this be you. With a little advice and some thought, you can start the savings account that makes the most sense for you right now. Two great options are a traditional savings account or a Roth IRA. To decide which is right for you, you should first understand what they are, and then weigh the pros and cons of each.
What Is a Savings Account?
You can typically open a savings account through a bank, much like a checking account. They are insured by the FDIC, which means that you would get your money back even if the bank fails. They carry interest rates, but these are typically much lower than with other types of savings.
What Is a Roth IRA?
IRA stands for Individual Retirement Account. You can choose from a traditional IRA or a Roth IRA, but the Roth version is often considered the gold-standard of retirement savings. Instead of opening this account through a bank, you go to a brokerage firm.
Often, people believe that Roth IRAs are investments. While they are similar, a Roth IRA is the account that holds your investment. It's like the binding on a book; it isn't the story, but it keeps it all together.
When Will You Need the Money?
If you are looking for a retirement account, a Roth IRA is the better bet. Because there is more risk associated with this account, the yields are higher. As you work, your money can make more money. Then, when your retirement comes, you can live comfortably.
However, if you're young and have nothing else saved, you may consider prioritizing a savings account for now. It can be helpful to have three to six months of living expenses saved in an emergency fund. This fund can keep you financially stable if you have a significant, unexpected expense or if you lose your job. Since savings accounts are easy to pull from, they are ideal for emergency funds.
How Will It Affect Your Taxes?
The main draw to the Roth IRA is the way it affects your taxes. First, you can write off the money you put towards it, up to $6,000 per year. This benefit comes in addition to anything you put in your 401(k).
Most importantly, the Roth IRA allows you to lock in the tax rate you currently pay. While traditional IRAs charge taxes when you retire and need to use the money, the Roth IRA allows you to pay the taxes now and pay nothing when you retire. Furthermore, you can take the money from your Roth IRA before you retire without paying taxes. You can even use it to pay for college for your children.
A savings account, on the other hand, won't affect your tax bill much in either direction. You won't get a tax credit for stashing your money in this account, but you won't be penalized either.
Roth IRA Eligibility
Roth IRAs are an excellent solution for many workers. However, their tax benefits mean that these accounts are off-limits to some of the highest earners. Depending on your adjusted gross income and family size, you may not be able to open such an account. In that case, you may opt for a traditional IRA or another form of savings.
Consider a Combination
Since you only get tax benefits for contributing $6,000 per year in a Roth IRA, some people choose not to contribute past that limit. If you put that much in your IRA and still have money to save, you can put the rest into a savings account. It doesn't have to be all or nothing!