Key takeaways
- Savings account rates always tend to lag behind borrowing rates, but the gap is particularly wide in 2022. Savings accounts aren’t yielding impressive returns and are losing money to inflation.
- You can get better yields with I bonds at present, but long-term goals may be better served by investments in the stock market.
- There are still circ*mstances where keeping money in a savings account makes sense, even if rates are relatively low.
Despite the fact that the Federal Reserve keeps upping interest rates, the yields currently offered on savings accounts aren’t incredibly attractive. The highest offers on the market fail to keep meaningful pace with inflation, which means any money you hold in those accounts quickly erode in value.
That doesn’t mean savings accounts don’t have their place, even with relatively low interest rates. It just means that if you have money you won’t need to access over the next 12 months and beyond, there are more profitable places to store it.
Savings account yields aren’t going up as quickly as interest on debt
Banks have been raising the APR on debts like mortgages but haven’t been raising the APY on savings accounts at the same clip.
You can find higher-than-average interest rates if you take the time to shop around. The highest offering as of early October was 3.25% APY, according to Ken Tumin, a senior industry analyst for LendingTree.
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While the rates on CDs are marginally better, they are still facing the same problem. The average 60-month CD has an average rate of 0.74%, according to the FDIC, and the highest rate is currently 4.25% APY.
Even though savings rates tend to lag behind borrowing rates, the gap between the two is abnormally large at this point in time. To illustrate this discrepancy, note that rates on conventional 30-year mortgages were above 7% in October of 2022. By contrast, when mortgage rates were 10.30% in 1990, 6-month CDs were paying 8.57%
Given today’s high rate of inflation, these comparatively low rates on savings products are extra harmful. The value of any money in your savings account is being eroded by inflation as even the interest rates of the highest-paying savings accounts trail far behind the 8.2% inflation we’ve seen over the last year.
Alternatives to savings accounts
If inflation is eating away at your cash’s value, you do have options outside of a savings account or CD.
There are currently two higher-yield alternatives. One is better suited for short-term savings goals, while the other is better suited for long-term goals.
Short-term goals: I Bonds
Generally speaking, bonds are not performing well right now.
But there is a unique beast among treasury bonds: the I bond. Most bonds require 30 years of ownership before reaching maturity, but I bonds allow you to cash out after just 12 months. With current rates, the return is pretty incredible.
For I bonds purchased through Oct. 31, 2022 will earn a 9.62% annualized return for the first six months. For the second six months, rates are projected to be 6.03%, for an overall annualized return of 7.82%.
This is much higher than anything you can earn on savings products at the moment, and the rate even rivals what long-term investors hope to get out of the stock market – only with far less risk.
There is a caveat, though. If you sell your I bond before owning it for five years, you’ll lose the last three months’ worth of interest. So in order to get your 12 months’ worth of returns, you’d actually have to sell at 15 months. Even so, the payout beats what you could currently earn using a CD.
The new rates are expected to be lower, and the rates released in May could move either up or down from there, depending on what’s happening with inflation.
Long-term goals: Tax-advantaged retirement accounts
If the time horizon on your savings goal stretches over decades, you could also consider investing your money in the stock market.
If you were to take a snapshot of the largest 500 companies in the U.S. market, or the S&P 500, you would see an 11.88% average annualized return. When you adjust this for inflation, it’s somewhere around 8.5%.
You could invest this money in a tax-advantaged retirement account, like a 401(k) or Roth IRA. These accounts come with certain tax advantages that can further protect your investments from erosion.
There are two types of accounts: tax-deferred and tax-exempt.
Tax-deferred accounts allow you to deduct your contributions from your income this year, thus lowering your current taxable income. Traditional IRAs and 401ks are examples of tax-deferred accounts.
Tax-exempt accounts give you limited options to deduct your contributions today, but when you reach retirement age, you’ll be able to take distributions without paying any taxes on either the principal investment or interest earned. A Roth IRA is an example of a tax-exempt account.
Tax-advantaged retirement accounts do come with contribution limits, though. For example, the contribution limits for 2022 are:
- 401(k) Under age 50 – $20,500 max
- 401(k) Age 50+ – $27,000 max
- IRA (Roth and traditional) Under age 50 – $6,000 max
- IRA (Roth and traditional) Age 50+ – $7,000 max
For 401(k)s, these numbers reflect only your contributions as an employee. Your employer is allowed to contribute even more money to your 401(k) through company match policies.
Taxable retirement accounts for higher incomes and savings rates
If you max out your tax-advantaged retirement accounts, or simply don’t want to wait until retirement age to cash out your investments, you can open a taxable investment account.
It won’t give you the same tax advantages, and there is more risk associated with shorter time horizons. But if you have a higher income and a savings rate that follows suit, you could opt to invest your money in the market after calculating the tax implications.
To manage your investments intelligently regardless of time horizon, consider an Investment Kit run by AI. These kits can help you reach your investment goals while optimizing for your taxes and time horizon.
The Advantage of Savings Accounts – Even Ones with Low Rates
One major advantage savings accounts have over treasury bonds and tax-advantaged retirement accounts is liquidity. You can access the money whenever you need it without penalty.
While there are some select circ*mstances where you could use a Roth IRA to cash out investments early, having your money invested in the stock market is riskier short-term – whether that money is held in a tax-advantaged account or not.
The bottom line
If you have a healthy emergency fund, you probably do want to keep excess cash somewhere other than a savings account with today’s lagging interest rates.
If you have a time horizon that stretches over decades, investing in the stock market is likely to yield greater returns than the money sitting in a high-yield savings account, though it does come with more short-term risks.
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