Savings Plan vs Investing: Where Should Your Monthly Money Go?

The savings plan vs investing question is really a question about time. Over three years a savings account and a stock fund end up within a few hundred dollars of each other, and the savings account cannot lose. Over twenty years the fund ends up with $112,000 more, and it has probably lost money in at least three of those years along the way. This guide puts $500 a month through both in the savings plan calculator and its investing counterpart, then sorts the decision by what the money is for.

The two paths

A savings plan is monthly deposits into a high-yield savings account, a money market account or a CD ladder. The rate is modest, 4% at the time of writing and 0.5% a few years ago, the balance never falls, and the money is FDIC-insured and available on demand. Interest is taxed as ordinary income each year.

Investing is monthly deposits into a brokerage or retirement account holding stock and bond funds. A diversified stock portfolio has averaged about 10% a year before inflation over the last century, with individual years ranging from a 37% loss to a 50% gain. Bonds have averaged around 5%. A balanced mix might be projected at 6 to 8%. Gains are taxed when you sell, at capital gains rates in a taxable account, or deferred in a 401(k) or IRA.

The savings return is close to certain. The investment return is an average that you may not get in your particular twenty years.

0 a month, both ways

At three years the 8% investment is ahead by $1,249, which one bad quarter would erase. At ten years it is ahead by $18,000. At twenty years it is ahead by $112,000, and even the cautious 6% case beats savings by $48,000. The gap is compounding: the extra four points of return are small in any one year and enormous over many.

Those investment figures are a smooth 8% every year, which never happens. Real sequences have years of −20% followed by years of +25%, and the final balance depends on which years come when. Over twenty years the smoothing works out; over three it does not.

Sort by horizon

Under three years: savings. The investment’s expected lead is a few hundred dollars and its possible loss is thousands. A down payment, a car, next year’s tuition, the emergency fund: all savings.

Three to seven years: mostly savings, with a case for a conservative mix if the date is flexible. A goal that can slip a year or two can carry some market risk; a goal with a fixed date cannot.

Over seven years: investing, in a tax-advantaged account where possible. The longer the horizon, the lower the odds that the market finishes below the savings account. Historically, twenty-year periods in US stocks have never ended with a loss, though several ten-year periods have.

Sort by what you can stand

A 30% drop in year eight of a twenty-year plan is normal and recovers on average within a few years. Whether you can leave the money alone through it is the question that decides whether investing works for you. If a drop would make you sell, the realised return will be far below the average, and the savings plan would have been better. People who are honest about this split the difference: a balanced fund, or part savings and part investing, so the drop is smaller and bearable.

Taxes change the comparison

Savings interest is taxed every year at your income tax rate. In the 22% bracket, 4% becomes about 3.1% after tax.

Investment gains in a taxable account are taxed only when sold, at long-term capital gains rates of 0, 15 or 20%, so 8% becomes roughly 6.8% after tax if held for years, and the tax is deferred until the sale.

Investments in a 401(k) or traditional IRA are not taxed until withdrawal, and contributions reduce this year’s taxable income; in a Roth IRA, qualified withdrawals are tax-free. For a retirement goal this is the deciding factor. The retirement savings calculator shows what yearly contributions grow to tax-deferred over decades.

A 529 plan does the same for education savings in most states, which moves a ten-year college fund from the savings column to the investing column.

Fees and inflation, the two quiet variables

Fund fees come straight off the return. An index fund charging 0.05% a year leaves 8% almost untouched; an actively managed fund or an adviser platform charging 1% turns 8% into 7%, which over twenty years on the $500 plan is about $34,500 less. Check the expense ratio before anything else; it is the one part of the return you control completely, and the difference between 0.05% and 1% is larger than most people’s entire savings-account interest. The savings plan has no fee, which is one reason the gap in the table is smaller in practice than on paper.

Inflation works the other way. At 3% inflation, the $183,999 in savings after twenty years buys what $102,000 buys today, and the $296,474 invested buys what $164,000 buys today. Both lose some ground; the savings account loses more of it in relative terms because its return is closer to the inflation rate. Over long periods the question is not whether the balance grows but whether it grows faster than prices, and a 4% savings rate against 3% inflation barely does.

The split most people end up with

Emergency fund of three to six months of expenses in savings, built first. Employer 401(k) match captured in full, since a 50% match is a return no savings account or stock fund will ever pay. Then goals sorted by date: the short ones into the savings plan, the long ones into index funds in whatever tax-advantaged account fits. A monthly surplus of $500 might become $200 to the car fund and $300 to the Roth IRA.

Rebalance the split once a year. As a long goal gets close, move it from investing toward savings over the last three to five years, so a bad year just before the date does not cost you the goal. Target-date funds do this automatically for retirement.

Running your own comparison

Enter your monthly amount and the current savings rate in the savings plan calculator for the horizon you have in mind. Then enter the same amount and a return you believe, after fees, in the monthly investment calculator, and look at both the 6% and 8% cases rather than the best one. If the savings figure is within a few percent of the investment figure, the risk is not being paid for; save. If the investment figure is far ahead and the date is far away, invest. For a lump sum with a fixed date, the CD calculator prices the locked alternative. All the tools are on the homepage.

FAQs