A friend recently asked,
“What role does a savings account play in long-term financial planning? I have a savings account, but I don't generally use it by the time I've contributed to my 401(k), Roth and HSA. Everything else left over goes into my checking account which generally operates as a checking/saving combo. That is probably sub-optimal. I'd love to hear your thoughts.”
First, let’s define savings. Technically, any amount of money directed towards a retirement account, college savings account (529), health savings account (HSA), or regular savings account at a bank can be labeled “savings.”
For purposes of this article, I’ll define savings as money saved for short-term expenses (we’ll define this later on) which is not invested in a bond or stock, but remains as “cash” or as accessible as cash.
Understand and Cover Your Daily Expenses
My friend expressed that he typically directs remaining cash to his checking account, with his savings account rarely being utilized. He’s right that this isn’t optimal. Checking accounts make accessing cash extremely easy, but they aren’t a great saving tool, paying very little interest.
My suggestion with checking accounts is to maintain two months of cash to cover day-to-day expenses. Maintaining two months of expenses keeps your checking account balance at a minimum while also providing some wiggle room if you have unexpected expenses come up in any given month. Additional cash beyond the two-month buffer could be directed to a higher interest-paying savings account.
So how are savings account optimally used? Here’s some advice on how to approach savings.
Short and Medium-Term Expenses
Savings planning is cash flow planning, and with any cash flow scenario it’s crucial to understand when the cash will be needed. The further out you go, the greater risk you could potentially accept, all else being equal, and thus the funds could either be kept as cash, invested in a CD, bonds, or even the stock market. This is really what categorizes different types of savings: understanding when the funds will be needed.
Cash in a savings account should be kept for short-term expenses. I define short-term as an imminent need -- meaning you may need to draw on it at any time -- and up to 5 years. Some example of short-term savings includes an emergency fund and savings toward goals extending out to about 5 years, like a family vacation or small down payment on a home.
I define any planned expenses greater than 5 years out to be “medium-term.” To be clear, I use this term loosely to suggest that someone could potentially invest some of the money into a combination of bonds or stocks to perhaps receive additional interest or growth. Of course, all of this depends on your risk appetite. Savings, as defined earlier, are not ideal for investments such as bonds or stocks. Short-term expenses are better saved for using savings accounts or other insured bank products.
If you don’t yet have sufficient emergency savings, it would be wise for you to decrease contributions toward medium and long-term financial goals for a time and focus on building up an emergency fund. This should be the first priority of any financial plan.
An emergency fund should cover three to six months of a family’s essential expenses. Obviously three to six months of savings is the difference of thousands of dollars for many families. How do you know whether to lean towards three months or six months of expenses? Here are two scenarios to help illustrate:
David works as a physician at a clinic owned by a large healthcare provider. He makes a good living, having worked there now for over 10 years. He plans to work at the clinic until he retires, where he plans to live off his retirement and collect on the pension his company has set up for him.
John is a salesman. He makes great money, but his salary is a bit unpredictable, swinging back and forth depending on how he performs that month. He’s hopped around to different employers -- this is his 4th company in 7 years. John is entrepreneurial at heart, and is contemplating forming his own marketing company in the next few years.
David’s job security (in a high demand field) and his plans to stay at this employer suggest he could be okay having emergency savings for a shorter time period.
John’s situation is more volatile. He’s making a good living, but his overall employment picture is much less stable. His plans for starting his own business add to the uncertainty of a consistent income, therefore his emergency savings should be able to provide for a longer time period.
Once an emergency fund is saved up, it should be set aside in a high-interest savings account and be almost completely ignored. I stress this because it can be tempting to dive into these funds for unnecessary and non-urgent expenses. Don’t do it. Emergency funds are for absolute emergencies such as a job loss and subsequent unemployment, or for large, unexpected expenses with no other access to cash.
Savings, however, is not just for emergencies, but also plays an important role in saving for short-term capital expenses.
Capital Expenses vs. Day-to-Day Expenses
I’m currently the Treasurer of the Homeowner’s Association for a condo I own. It’s a fun little job. Managing the HOA finances introduced me to an important concept of financial management: capital expenditures.
Our HOA has a budget of expenses we expect to incur each month. These expenses are fairly easy to predict: trash and sewer, property insurance, electricity, landscaping, and so on. However, this year we had a large piece of electrical equipment breakdown. Not only was the expense not budgeted for, but working the cost into the budget (around $2,000) would have been a budget-buster!
Fortunately, we have a capital expense account. This separate savings account is earmarked for capital expenses that are typically large in nature, not fitting within the traditional guidelines of a monthly or yearly budget. Capital expenses can be unexpected, like broken down equipment, or expected, like estimating the expected life of an elevator motor or roof shingle replacement and building up capital savings towards those future needs.
A family can also set up a capital expense account, for which a traditional high-interest savings account is an excellent solution. A family’s capital needs can be expected, like a car purchase or vacation, or unexpected, like a dead furnace. Many unexpected expenses can fall into the “emergency” category and the emergency fund can be used, but short-term expected expenses can be planned to a certain extent, with money set aside in a savings account as well.
In this way, savings is what keeps a family’s financial life flexible. Real trouble comes to medium and long-term financial plans when short-term emergencies flare up. Selling long-term assets to cover emergency expenses can be ruinous to things like a retirement portfolio. High interest credit cards are often used as a fallback in emergencies, leading you down a dangerous road of expensive future payments.
Finding the Right Savings Account
As you can see, savings accounts are useful for saving for emergencies and capital expenses that can’t be accounted for in a monthly budget. When choosing a savings account, look for a provider who is trustworthy, provides convenient and fast accessibility to your funds, and pays a substantial interest rate above your checking account.
I personally use Ally Bank. This bank is completely online with no brick and mortar bank branches to speak of. This significant reduction in overhead costs allows them to pass the savings on to their customers, paying 1.00% annually as of November 2016. This is far more than you’ll find in any checking account and many savings accounts.
Interest compounds daily, is paid each month, and there are no monthly fees to speak of. They also have promotional offers occasionally for higher interest rate CDs. I tell you, it’s really cool to see a nice little chunk of interest roll into the account each month. You can simply leave it there for future growth through compounding, or do what my wife and I do -- pull out the interest and use it for Christmas gifts!
I hope this article sheds light on the role savings accounts play in a financial plan. Savings accounts help provide better financial structure to your short-term savings goals and create a cushion for unexpected costs. If wisely used, cash can be put into these accounts on a consistent basis, paying you a significantly higher rate of interest than a typical checking account.