Savings Vehicles

Congrats! Your budget is under control, you've paid off some debt, and you're now running a surplus. You are now ready to SAVE. So what do you do with that extra money in your bank account?

The first step is to get it out of your checking account. There are several reasons to set up different accounts for different purposes. The first is psychological; it is less likely you will dip into your retirement savings for a new pair of shoes if those funds are kept in separate accounts. The second is logical; some accounts offer more interest and potential for return but less liquidity.

Most people should have at least three accounts- a checking account for paying bills, a savings account for your emergency fund and short-term savings, and a retirement account that you do not plan to touch until you are at least 60 (typically a 401(k) or IRA). Some financial planners recommend that you open a separate account for each short-term and intermediate financial goal, however, that sounds like a lot of paperwork to me. I think it is absolutely fine to save for your wedding, home renovation, and upcoming vacation in the same account as your emergency fund and just track the overall amount you need for each goal. However, it goes back to the psychological- if you are more comfortable with four different accounts, or you want to be able to see how much you have saved for each goal right on your bank statement, then go for it.

Here is a run-down of common accounts that can be used for your savings goals:

Checking accounts
Savings accounts
Money market funds
CDs
IRAs
Company Retirement Plans

CHECKING- Interest rates are at historical lows right now (seriously, 4% mortgages?!). Good for loans, bad for savings. Especially bad for checking accounts, which often charge you fees and pay no interest. However, there are great deals out there. I recently switched from a large bank to a credit union, which has lower costs and actually pays me some interest to hold my money. Compare rates at http://www.bankrate.com/ or http://www.depositaccounts.com/, and make sure you understand all of the fees involved.

How much you keep in your checking account depends heavily on your spending habits, and how many people are accessing the account. If you are the only person on the account and you keep impeccable records, then you probably only need the amount to pay your bills and a buffer of a few hundred dollars. If you are like the rest of us and sometimes spend more than you plan in a pay period, or if both you and a spouse are drawing from the same account, then you should keep at least $500 in the account or keep it linked to another account in case of overdraft. Linking your account to a line of credit or savings account can prevent costly overdraft fees, but if you find yourself making a habit of accessing those funds then you need to reexamine your budget.

Remember that the purpose of a checking account is to keep money you plan to use in the very near future. Therefore, make sure you can access your funds easily and free of charge.  Look at ATM, electronic, and check writing fees, and make sure either the bank or the ATM is convenient to your regular schedule.

SAVINGS ACCOUNTS- Even with the best checking account, chances are that you can get better interest rates with a savings account. Less liquid, more interest. Look online at http://www.bankrate.com/ and http://www.depositaccounts.com/ to compare rates, and don't limit yourself to the bank that holds your checking account. Online savings accounts, including Ally, ING Direct, and American Express, offer competitive rates and make it easy to transfer money to and from your checking account.

Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals

MONEY MARKETS- Money market accounts (MMA) and money market funds (MMF) typically offer slightly higher interest rates and more restrictions. Money market accounts are offered through banks, are FDIC-insured, have minimum balance requirements, and are limited to six withdrawals per month. Money market funds are mutual funds that are required to hold low-risk securities. They are not FDIC-insured. They usually require you to keep a minimum balance.

Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals

CDs- Certificates of Deposit are offered by banks, FDIC-insured, and often offer higher interest rates. In return, you agree to leave your money in this savings tool for a certain time period, and you will be penalized if you take your money out early. The longer the CD term, the higher the interest rate typically. Some people choose to "ladder" CDs, in which case you buy longer-term CDs but space out your purchases every month/quarter/year. For instance, you may buy a 2-year CD every six months. This way you receive a higher interest rate than if you just bought a six month CD, but you still have a portion of your money available every six months. If you really like CDs and choose them as your investment vehicle, then I highly recommend laddering. Be careful to read the terms of a CD to make sure it has low fees and fits your needs. I personally do not like CDs over one year right now because interest rates are so low and you are locking yourself in at that low rate.

Great for: Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals (as long as you time the maturity of the CD with when you will need the funds).

IRAs- Individual Retirement Accounts are personal accounts that you can start on your own to save for retirement, outside of a company retirement account. Traditional IRAs are available to anyone without a company retirement plan, or anyone who has a retirement plan but whose adjusted gross income (AGI) is less than $68,000 (if you file for taxes as single) or $112,000 (if you are married filing jointly). Roth IRAs are limited to those with an AGI  of less than $125,000 (single) or $183,000 (married filing jointly). The maximum IRA contribution is $5,000 per year (phased out as you get near the maximum income limits). This may not seem like a lot, but if you put away $5,000 from the time you are 30 until you turn 65, and earn 8% a year on your investments, you would have over $850,000 at 65!

IRAs can be confusing because they are an account, not an investment vehicle. You can invest in a number of different vehicles within your IRA account, for instance, you may have one IRA with mutual fund and stock investments, another in a CD, and another with only bonds. You can switch the investments within your IRA at any time and move it to a new IRA account (rollover), but you cannot take the money out of that IRA "bucket" and move it to your checking account without penalties.

Traditional IRAs are tax-deferred, which means you do not pay income tax on your contribution when you earn it, and you don't pay capital gains tax as you earn money off interest and investments. You will pay income tax when you withdraw the funds. Great incentives to save, but the government isn't just giving you these tax breaks for fun. These funds are earmarked for retirement, and you will be penalized 10% of any funds that you withdraw before age 59.5, in addition to paying income tax on the whole amount! That means that if you have a $10,000 IRA and you decide to pull it out to go to the World Cup, you will owe $1,000 in penalties AND owe income tax. If you are in a 25% bracket, you would pay $2,500 in taxes, which means that you only get $6,500 of your $10,000. So make sure that you leave the money in your retirement account for retirement!

Great for: Retirement Savings

Roth IRAs do not offer the immediate tax deduction of a traditional IRA, but allow for the funds to grow tax-free and be withdrawn tax-free. If you are in a low tax bracket or expect to be in a higher bracket in the future (either because of your earnings or higher tax rates), then this is a very powerful tool. You pay the income tax at your current rate and can withdraw it tax-free in the future when your tax rate is much higher. The other amazing feature of a Roth IRA is its flexibility- you can withdraw your contributions at any time without penalty! You are penalized for withdrawing the growth in your Roth IRA, but even then you are given some exclusions, including a first-time home purchase.

Great for: Retirement Savings, First time Home Purchase

COMPANY RETIREMENT PLANS- 401(k)s, Simple IRAs, and SEP IRAs are just a few of the retirement accounts that your company may offer. Companies will often match their employees' contributions, so make sure you are always contributing to the max! A dollar-for-dollar match is a 100% return in the first year, so don't ignore it. As with IRAs, you are penalized for withdrawing your company retirement funds before age 59.5, and you may need a certain amount of service with the company before you are allowed to keep all of the contributions they make on your behalf. When you leave a company, you are able to roll your "vested" funds (your contributions and growth plus the amounts you are entitled to from the company contributions and its growth) to an IRA or your new 401(k) plan. Company retirement plans can have high fees, but new regulations are forcing disclosure of all fees and encouraging companies to offer independent financial advice. This is a huge benefit!

Great for: Retirement Savings

We have just touched on the main points of a few types of accounts that can help you save for your financial goals. In the following months you will see more detail about these accounts, particularly retirement accounts. In the meantime, please comment and tell me how you separate your savings into different accounts.