The idea of spending less and saving more runs counter to the "instant gratification" so deeply engrained in our culture. Making tough decisions today, though, ensures a more stable financial future. "When it comes to savings, we recommend a three stage approach," says Elliott Orsillo, a chartered financial analyst and the co-founder of Season Investments. First, set a budget and analyze your spending. Next, build a cash reserve that will cover three to six months of expenses. Finally, invest in your future. "The goal should be to try and save 10 to 20 percent of one's income."
Savings Account: What Is It?
A savings account is one of the most straightforward saving options available. It's essentially a place to keep your money, with a very small return, until you want to use it. Many savings accounts do allow withdrawals, though every bank has its own protocol regarding how much and how often you may withdraw. Most banks and credit unions provide the option to open a savings account, though some require a low minimum daily balance. You can also opt for a high-yield savings account, which earns you more interest in exchange for maintaining a higher minimum balance.
Savings Account: Who's It For?
Savings accounts are an option for everyone. Because there's very little risk involved, it is a safe option that requires little to no financial savvy. Savings accounts are not for people who want to make a lot of money off of their investments, as they typically earn very little interest.
CDs: What Are They?
A CD, or certificate of deposit, is short-term savings product offered by many banks and credit unions. It's similar to a savings account in the sense that it's low-risk. However, unlike a savings account, you are unable to withdraw from your CD while it's maturing without incurring a penalty. In exchange for not touching the money, you earn a slightly higher, fixed interest rate on your principal than you would from a regular savings account. Still, CDs do not offer as high of a return as more aggressive savings products. Typically, CDs have a three-month to five-year maturity date and require around a $500 minimum. The interest you accrue on your CD is taxed in the year you earn the interest.
CDs: Who Are They For?
CDs are a savings option for people who know they will not need the money while it's maturing. They're also ideal for those who want to make a short term investment instead of a long-term investment. Because they do yield a higher interest return than a standard saving's account, but are still low-risk, CDs are preferred by those who may otherwise leave their money untouched in a savings account.
Savings Bond: What Is It?
Savings bonds are issued by the U.S. government. Like CDs, they're a low-risk investment option with a fixed interest and set maturity date. However, unlike CDs, those maturity dates are usually set for much longer into the future -- typically 30 years with a 10-year optional extension period. Savings bonds aren't subject to local or state taxes. Federal taxes may be deferred until your CD reaches its maturity.
Savings Bond: Who's It For?
Because of their fixed interest rates, savings bonds are ideal for investors who want a predictable savings option. The fact that they're backed by the government makes them virtually risk-free, which is also appealing to some. While a non-volatile investment option, the return on savings bonds is usually low compared to more aggressive plans. If you want a higher return, savings bonds are probably not for you.
401k: What Is It?
A 401k is an employer-sponsored retirement investment option that's funded with tax-deferred money. Before taxes are taken from your paycheck, funds are taken and directly deposited into the 401k. It's not meant to be withdrawn from until you reach retirement age. If you do withdraw before then, you'll be taxed and possibly fined. Some employers will match your 401k contributions up to a certain percentage, essentially doubling the amount you invest.
401k: Who's It For?
A 401k is a preferred savings method for employees whose companies provide them with the option. "If someone is fortunate enough to work for a company that matches 401k contributions, they should max out the company match," notes Orsillo. For example, if your employer provides a full match up to 5% of your gross pay, you should contribute up to that 5%. This doubles your investment.
Traditional IRA: What Is It?
A traditional "Individual Retirement Account" (IRA) is an account in which you contribute pre-taxed income (up to a certain amount, annually). Unlike a standard savings account, an IRA is typically more aggressive when it comes to earning a return on your investment. It's intended to be withdrawn from only once you reach retirement age and you pay taxes on your investment gains only once you begin withdrawing.
Traditional IRA: Who's It For?
Depending on your tax-filing status and other factors, contributions to a traditional IRA may be tax deductible. Those tax deductions can put you into a lower tax bracket, thereby lessening your tax paying burden. For this reason, traditional IRAs are ideal for high earners. "In general, we like IRAs better than 401k's because they offer more flexibility with lower fees," notes Orsillo.
Roth IRA: What Is It?
You contribute to a Roth IRA the same way you would a traditional IRA. The biggest difference between the two is that, unlike a traditional IRA, you contribute already taxed money into a Roth IRA. As a result, you do not have to pay taxes on your Roth IRA once you begin withdrawing from the account in retirement. Contributions made to a Roth IRA are not tax deductible as they are for a traditional IRA.
Roth IRA: Who's It For?
"Roth IRAs are fantastic tools for young people because they allow tax free growth and withdrawals," says Neal Frankle, a certified financial planner and founder of both Wealth Pilgrim and MCMHA.org. "Also, since younger people may not be earning as much, their tax bracket is low." Those with lower incomes benefit more from a Roth IRA since they're already able to pay a low marginal tax rate and won't be taxed on their IRA money in the future, either.