Bank savings are incredibly thin these days, and taxes chew away at what little interest you earn.
You are probably stuck with the problem if you prize the safety offered by FDIC-insured bank accounts, but you can ease the tax burden a little by using a bank IRA instead of your classic savings account.
When most savers and investors think of individual retirement accounts, they think of mutual fund companies and brokerages. But banks offer them, too, and if you put money into a savings account or certificates of deposit within an IRA, you can postpone the tax bill until you withdraw the money, rather than face it year after year.
Regardless of whether it’s earned from a taxable account or tax-deferred IRA, interest is taxed as ordinary income at rates from 10% to 35% for most people. The only difference is the timing: With a taxable account, tax is owed for the year the interest is earned, but with an IRA, tax is not due until the money is withdrawn.
Postponing the tax bill allows you to keep more money in the account, boosting the effects of compounding. No one’s getting rich on bank savings these days, because yields are so low, but it’s still a good practice to avoid tax bills for as long as you can.
Keep in mind, though, that you cannot take money out of an IRA until age 59 ½ without paying a 10% penalty on top of the tax on the account’s interest income. An IRA, therefore, makes no sense as a rainy day fund unless you are past that age. Nor would it make sense for any other savings you are likely to need before that age, such as for a down payment on a home.
So what does that leave?
In addition to its everyday uses for paying bills, and as a backup for emergencies, cash can stabilize a long-term investment portfolio. Stocks and bonds can rise and fall, but FDIC-insured savings will not lose value. Many investors, therefore, keep cash that they have no intention of spending in the short term.
A savvy investor has an asset allocation plan that divides the portfolio among stocks, bonds and cash, generally according to the investor’s age and tolerance for risk. Typically, more of the portfolio goes into bonds and cash as the investor ages, so as to emphasize safety over growth.
Many investors also divide their holdings among tax-deferred accounts like IRAs and 401(k)s and taxable accounts, including bank savings accounts. You don’t need to apply the same asset-allocation goals to each type of account so long as you keep on target overall.
Investments, such as stocks, which produce most of their profits through long-term capital gains, often do best in taxable accounts, because the maximum long-term capital gains tax rate is only 15%. The same investment held in an IRA or 401(k) could be taxed at the income tax rate up to 35% that applies to all holdings in tax-deferred accounts.
Interest earnings produced by cash and bonds are taxed at those higher income tax rates in both types of accounts, so there’s nothing to lose by using an IRA to postpone the tax, so long as you won’t need quick access to the money.
Most banks offer IRAs that can contain savings accounts or CDs. Use the BankingMyWay CD Rate search tool to find the best deals, and be sure to ask about fees before opening an account. With yields so low, even a small fee can take a big chunk out of your earnings.
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