Looking to put some money away and start saving for a financial goal? Setting up a savings account is a smart way to do it. There’s no shortage of options when it comes to accounts. So what exactly is a savings account, and what are the important differences between the available choices?
Savings accounts – the basics
Financial institutions such as banks and credit unions offer savings accounts to customers who want a safe place to grow any extra money they don’t need for day-to-day spending and other regular obligations, such as mortgage payments or utility bills.
In exchange for the customer making fewer withdrawals, payments, and other transactions while keeping their money in the account for months or years at a time, the financial institution usually pays a higher interest rate on savings accounts than it does on chequing accounts. Some chequing accounts don’t pay any interest at all.
For the most part, savings accounts are best used for goals you’re trying to reach in the short to medium term, say a vacation or new appliances, rather than long term goals such as retirement. The main reason is inflation, which tends to rise more quickly than interest rates, meaning the purchasing power of your cash savings slowly diminishes over time.
Savings accounts don’t generate the same rate of return you might expect from other types of investments, such as term deposits or bonds. However, they do offer the value of security and stability. Up to a certain amount, depending on your institution and province, your deposits are insured by the federal government. Unlike mutual funds and equities, you’re never exposed to short-term market declines that could erode the value of your savings right when you want to cash out.
Another important difference is ease of access. With a savings account, you have flexible, penalty-free access to your savings whenever you need any cash. With some investments, your money is tied up for a fixed period, meaning you might have to pay a fee to get hold of it in an emergency.
Daily Interest Savings Accounts
One of the most effective methods of growing your savings is taking advantage of the power of compound interest. Simply put, this refers to the additional interest you earn on interest you’ve already earned. These fractional amounts add up over time and slowly boost your savings total. The more frequently interest is calculated, the faster your savings will grow.
Most savings accounts pay interest at the end of each month. Any interest you earn is added to your balance, and the next month your interest is a few cents or a few dollars higher. When interest is calculated daily instead of monthly, you’ll end up earning slightly more over the course of 12 months.
For reasons of simplicity, most financial institutions don’t show the daily interest you earn on such an account. Instead, the total is tracked separately and paid on a monthly or bi-weekly basis.
Tax-Free Savings Accounts
A relatively new addition to our financial landscape, tax free savings accounts (TFSAs) are an invaluable tool for savings goals of all kinds, both short and long term. Available at most financial institutions, these registered accounts are available to Canadians over the age of 18. In 2020, the maximum annual contribution amount to a TFSA is $6,000, but various annual maximums ranging from $5,000 to $10,000 have applied in different years since the accounts launched in 2009.
As the name suggests, earnings generated within tax-free savings accounts are not subject to income tax, even when you withdraw funds. This makes TFSAs an especially effective way to reach your financial goals.
TFSAs are flexible, allowing you to make penalty-free withdrawals at any time, and even replace what you took out the following year. You’re also allowed to top up your lifetime contributions to take advantage of any unused space from previous years. However, take care not to over-contribute, or you’ll have to pay a monthly penalty on the excess amount until you withdraw it.
The flexibility of TFSAs also applies to the kinds of investments that can be held within them. It’s possible to simply hold cash in a TFSA, as you would with a traditional saving account, but such an approach fails to take full advantage of the account’s tax-free earning potential. As long as you’re comfortable with the risks of some ups and downs, you’re better off using your TFSA to invest in a mix of equities (stocks and bonds), mutual funds, and other financial products, because they’ll usually generate a better rate of return than cash. The result: you earn more money on your money, and keep more, too.
Which savings account is right for you? Talk to your financial advisor or visit us at Moya Financial to learn more about our options.
