Savings Account vs. Money Market Account

[hellooperator]

Hi there,

I am a recent graduate who has been working for the past 8 months. I live in the city and make a good income. Starting in August, I enrolled in a Roth IRA and put away 10% of my paycheck every month to that account. I work at a start up so I was able to early exercise all my options (to start the capital gains clock early) and I rent an apartment where I had to put down a full months rent for the deposit. Starting January, I will finally be able to start saving a good amount of my paycheck instead of having a bank account that really hasn't changed much do to all the expenses.

I was wondering what I should do- keep it all in a savings account (it's a BofA money market savings but barely gets any good interest) or what I was thinking is keeping maybe a couple months rent in a checking account/savings account and putting the rest to an investment account and investing it in index funds and mutual funds.

Are there any recommendations on types of accounts, promotions...etc?

[thesimplemoneyblog]

It would make sense to work on the following:

1) Establish an emergency fund of 3-6 months of living expenses (rent, car payment, food, etc.) and keep in a money market, saving account, CD, or other highly accessible cash-type account.
2) Fund the maximum to any 401k/403b you have available in order to take advantage of any employer match (if available).
3) Fund the maximum to your Roth IRA ($5,000 for 2012 and $5,500 for 2013).
4) Consider investing any additional savings in mutual funds, ETFs or other more long-term investment strategies as they are appropriate for your goals. Your particular goals and objectives (buying a home in a few years, buying a new car, setting money aside for children's education, extra retirement savings, etc.) would dictate how conservatively or aggressively to invest these types of funds.

The actual ranking of priority for 2-3 above really depend on your goals though (how/when you might consider retiring, what your current expenses are, future home purchase, children's expenses, wedding, or whatever else there could be of priority in your life as a recent graduate).

Great job on starting the good savings habits now!

[marvholly]

I am going to go against the (so far) grain here.

I would go w/a money market account. Generally the interest rate is MUCH better. My Ally account is paying as much as a 12-18 month CD.

Be aware:
most have minimum deposit requirements
ALL limit the number of withdrawals/month (6?), DEPOSITS DO not COUNT-THEY ALWAYS ARE WILLING TO TAKE YOUR $$
most have minimum withdrawal requirements ($500?)

This works for me as I DO keep a $1000 buffer in my checking account and I cannot see ANY need for a withdrawal of <$500/

[hellooperator]

Thanks for all the help so far.

I will be keeping a cushion of a couple months paychecks in the checking/savings, but after that does anyone recommend a MMA or other investment strategy I could use to start making my money get better rates?

Should I put it into a Fidelity account and diversify my money every month with different index funds?

[bUU]

The accounts being discussed here ("deposit accounts", "savings accounts", "money market accounts", CDs, etc.) are federally-insured accounts, which is most appropriate for your emergency fund, which should be much more than a couple of months of expenses. The average recommendation I've seen is 12 months, with the low-end of the range, excluding outliers, being 6 months.

Now the "problem" with this is that insured deposit accounts are paying diddly these days. It does tend to prompt a lot of us to start thinking about incurring more risk with our emergency fund than we should. Think about it: Just because interest rates suck doesn't reduce the chances that you'll need your emergency fund - if anything, it increases the chances.

So what to do? I've searched around for the absolute best rates for liquid, insured account. Right now, that's Ally Bank. (When I went looking, it was ING Direct and Discover Bank. Everbank is another bank that typically pays better than average interest.)

With regard to what's implied in the rest of what you've asked, once you've got the 6-18 months of cash in insured deposit accounts, then you can start aiming for some longer-term investments. When you do that, you don't really gain much by trying to achieve diversification all by yourself. There are numerous "Total" market index funds that handle diversification within a market for you. What you need to focus on is diversifying your asset allocation, i.e., Domestic stock, International stock, and bonds. For example, at Vanguard, you can get all the diversification you'll need from three funds: VTSMX, VGTSX and VBMFX.

[violet80907]

Think about it: Just because interest rates suck doesn't reduce the chances that you'll need your emergency fund - if anything, it increases the chances

This - and I'll expand slightly. In late 2008, people's index fund investments were worth about half of what they had once been (at the peak). At that same time, millions of people found themselves without work.

Your emergency fund needs to be able to ride out the emergency when it can (because you didn't lose your job), but be there in its entirety when you need it.

[hellooperator]

Think about it: Just because interest rates suck doesn't reduce the chances that you'll need your emergency fund - if anything, it increases the chances

^good quote, I underestimated that emergency fund. Would it be immature then to start splitting and funding both accounts now...for example, take a paycheck and what ever is left after expenses and do like an 80-20 or 70-30 split into both accounts?

Also thank you for the Vanguard suggestion. Would you advise I keep BofA for my emergency funds still or transfer it to a better paying account? Does anyone have a recomendation for an investment account based on the best promotions...etc.?

[hellooperator]

I was thinking of a Fidelity Cash Management Account for everything (keep a small checking account here locally at the BofA for any transfers of accounts or cashiers checks or anything) and that way I can also do my investing from one centralized location.

[bUU]

Would it be immature then to start splitting and funding both accounts now...for example, take a paycheck and what ever is left after expenses and do like an 80-20 or 70-30 split into both accounts?

You mean checking and savings? It depends on their relative interest rates. As I think I mentioned earlier, one of my banks offers higher interest rates on checking, with the balance I have, so I am just using the checking account. If the situation was reversed, I would put all except one month's worth of expenses in the savings account.

Would you advise I keep BofA for my emergency funds still or transfer it to a better paying account?

I just got back from BoA after closing my accounts there. I stopped off on the way home at Fidelity and deposited the proceeds. I think it would be very difficult to make a good case for any individual depositor to have an account at BoA at this point... my assumption is that every who is still banking there is either unaware of the alternatives, as I was, or was too lazy to make the changes, like I was.

While I could make a good case for keeping my emergency fund in a local credit union (4% on the first $3k in savings!!! but only 0.15% for higher balances -- and 0.25%-0.45% on high-yield savings accounts and money market accounts), at this point our emergency fund is at an Internet bank. Ally Bank pays 0.95%, for savings (limit 6 transactions per month), so that's where I would put my emergency fund if it wasn't already at at another online bank earning pretty close to that rate.

I do have a Fidelity Cash Management Account, and that's what we're using instead of a checking account now. We have it linked to our online bank checking account (which, remember, we're basically using as a savings account), so we can sweep money back and forth as necessary. The Fidelity Cash Management Account doesn't pay much - so we keep only what we need for current expenses in it. Also, Fidelity doesn't do cash, so if you want a cashier's check or to deposit cash, you'll need another bank for that. But BoA isn't a good choice... find a credit union like the one I mentioned.

[Petunia 100]

When you are ready to invest, remember to max your Roth before investing in a taxable account. Your Roth contributions are available to you at any time for any reason, so it makes no sense to invest in a taxable account if there is still room inside your Roth.

[hellooperator]

When you are ready to invest, remember to max your Roth before investing in a taxable account. Your Roth contributions are available to you at any time for any reason, so it makes no sense to invest in a taxable account if there is still room inside your Roth.

Are you sure? I know your gains are taxable, but I thought any withdrawing from this account is subject to a 10% early withdraw fee + marginal taxation on the gains, unless you are withdrawing up to 10K for a house or medical expenses...

Or are you able to withdrawn your contributions (not interest earned) without any penalty?

[violet80907]

When you are ready to invest, remember to max your Roth before investing in a taxable account. Your Roth contributions are available to you at any time for any reason, so it makes no sense to invest in a taxable account if there is still room inside your Roth.

I believe this to NOT be true. From the IRS website:

To discourage the use of IRAs for purposes other than retirement, the law imposes a 10% additional tax on early distributions from traditional and Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2. The 10% additional tax applies to the part of the distribution that you have to include in gross income. It is in addition to any regular income tax on that amount.

There are further conditions that do allow some withdraws without the penalty, similar to the rules regarding standard IRA's. See IRA tax topic 557 for details. http://www.irs.gov/taxtopics/tc557.html

[bUU]

I believe this is the critical part of it:

The 10% additional tax applies to the part of the distribution that you have to include in gross income.

If you put $1000 into a Roth IRA, and you take $1000 out, how much of that do you have to include in gross income?

I believe the answer is $0.

The key can be found here: Publication 590, 2. Roth IRAs, Ordering Rules for Distributions

When you pull money out of a Roth, the first money that comes out is the money you put in (after-tax, remember) - the "contributions" (which is the specific word that Petunia used). That money doesn't haven't to be included in gross income.

The only part of the Roth that is subject to be treated as part of gross income is the earnings, defined I believe as that amount of the assets in the account in excess of your contributions. Leave the earnings in the account, and I believe you're not subject to any 10% tax penalty.

Now there are some complexities if what you're doing is a Roth conversion, but that's not what is being discussed, above, I don't think.

I could be wrong, though. I'm just starting to wrap my head around this stuff, myself.

[Petunia 100]

Are you sure? I know your gains are taxable, but I thought any withdrawing from this account is subject to a 10% early withdraw fee + marginal taxation on the gains, unless you are withdrawing up to 10K for a house or medical expenses...

Or are you able to withdrawn your contributions (not interest earned) without any penalty?

Yes, I am sure. And yes, contributions only, not earnings.

From IRS Publication 590:

Are Distributions Taxable?

You generally do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s)

Publication 590 (2011), Individual Retirement Arrangements (IRAs)

[Petunia 100]

I believe this to NOT be true. From the IRS website:


There are further conditions that do allow some withdraws without the penalty, similar to the rules regarding standard IRA's. See IRA tax topic 557 for details. Tax Topics - Topic 557 Tax on Early Distributions from Traditional and ROTH IRAs

Violet, the 10% penalty does apply to early Roth distributions on earnings, or conversions less than 5 years old. It does not apply to early Roth distributions on contributions, or to conversions at least 5 years old.