What Is a Savings Account and How Does It Work?

What Is a Savings Account?

A savings account is an interest-bearing deposit account held at a bank or other financial institution. Though these accounts typically pay only a modest interest rate, their safety and reliability make them a good option for parking cash that you want available for short-term needs.

Savings accounts may have some limitations on how often you can withdraw funds, but generally offer exceptional flexibility that’s ideal for building an emergency fund, saving for a short-term goal like buying a car or going on vacation, or simply sweeping surplus cash you don’t need in your checking account so it can earn a little interest.

How Savings Accounts Work

Savings and other deposit accounts are important sources of funds that financial institutions use for loans. For that reason, you can find savings accounts at virtually every bank or credit union, whether they are traditional brick-and-mortar institutions or operate exclusively online. In addition, you can find savings accounts at some investment and brokerage firms.

Savings account interest rates vary. With the exception of promotions promising a fixed rate until a certain date, banks and credit unions might change their rates at any time. Typically, the more competitive the rate, the more likely it is to fluctuate.

Changes in the federal funds rate can trigger institutions to adjust their deposit rates. Some institutions offer high-yield savings accounts with significantly higher interest rates for larger minimum deposits, which may be worth investigating.

Some conventional savings accounts require a minimum balance to avoid monthly fees or earn the highest published rate, while others have no balance requirement. Know the rules of your particular account to ensure you avoid diluting your earnings with fees.

Money can be transferred in or out of your savings account online, at a branch or ATM, by electronic transfer, or by direct deposit. Transfers can usually be arranged by phone, as well. 

Some banks limit withdrawals to six per month. The Federal Reserve set that limit as a requirement for savings accounts but then withdrew it in April 2020. Exceed six withdrawals with some banks, and the bank may charge a fee, close your account, or convert it to a checking account. The amount that can be withdrawn is limited only to how much is in the account.

Just as with the interest earned on a money market, certificate of deposit, or checking account, the interest earned on savings accounts is taxable income.

The financial institution where you hold your account will send a 1099-INT form at tax time whenever you earn more than $10 in interest income. The tax you’ll pay will depend on your marginal tax rate.

Pros of Savings Accounts Explained

Fast and easy to set up and move money: Holding a savings account at the same institution as your primary checking account can offer several convenience and efficiency benefits. Because transfers between accounts at the same institution are usually instantaneous, deposits or withdrawals to your savings account from your checking account will take effect right away.

Can be conveniently linked to your primary checking account: This makes it easy to transfer excess cash from your checking account and have it immediately earn interest—or transfer money the other way if you need to cover a large checking transaction. Because of the interest, it makes sense to keep any unneeded funds in a savings account instead of in your checking account, where it will likely earn little or nothing.

Up to your full balance can be withdrawn at any time: Your access to funds in a savings account will remain extremely liquid, unlike certificates of deposit, which impose a hefty penalty if you withdraw your funds too soon.

Up to $250,000 is federally insured against bank failure: Federal protection against bank failures provided by the Federal Deposit Insurance Corp. (FDIC) will keep your money safer than it would be under your mattress or in your sock drawer.

Cons of Saving Accounts Explained

Pays less interest than many other instruments or investments: The trade-off for a savings account’s easy access and reliable safety is that it won’t pay as much as other savings instruments. You can earn a higher return with certificates of deposit or Treasury bills, or by investing in stocks and bonds, if your time horizon is long enough.

Easy access can make withdrawals tempting: The ready availability of funds may tempt you to spend what you’ve saved.

Some savings accounts require minimum balances: Certain savings accounts request a minimum balance to avoid monthly fees or earn the highest published rate.

How to Maximize Earnings From a Savings Account

Although most major banks offer low interest rates on their savings accounts, many banks and credit unions provide much higher returns. In particular, online banks offer some of the highest savings account rates. Because they don’t have physical branches—or have very few—they spend less on overhead and can often offer higher, more competitive deposit rates as a result.

The key is to shop around, starting with the bank where you hold your checking account. Even if that institution doesn’t offer a competitive savings account rate, it will give you a frame of reference for how much more you can earn by moving your savings or opening an additional account elsewhere.

As you shop for the best rates, however, beware of account features that can curtail your earnings, or even drain them. Some promotional savings accounts will only offer the attractive rate they’re advertising for a short period of time.

Others will cap the balance that can earn the promotional rate, with dollar amounts above that maximum earning a paltry rate. Even worse is a savings account with fees that cut into the interest you earn each month.

How to Open a Savings Account

To set up a savings account, visit one of the bank or credit union’s branches, or establish the account online, for those institutions that offer it. You’ll need to provide your name, address, and telephone number, as well as photo identification. Also, because the account earns taxable interest, you’ll be required to provide your Social Security number (SSN).

Some institutions will require you to make an initial minimum deposit at the time you open the account. Others will allow you to open the account first and fund it later.

How Much to Keep in Your Savings Account

The amount you keep in your savings account will depend on your goals for the funds, or your use of the account. If you’ve set up the savings account to sweep excess funds from your checking account, your balance is likely to vary regularly.

In contrast, if you are building up to a savings goal, your balance will likely start low and increase steadily over time.

If you’ve instead established your savings account as an emergency fund, financial advisors typically recommend holding enough savings to cover at least three to six months’ living expenses, giving you a financial cushion in case you lose your job, face a medical issue, or encounter another money-draining emergency.

However, some analysts recommend keeping only some of that emergency fund in a simple savings account, while moving the rest of it to an account or instrument that earns a higher return.

In any case, note that deposits at banks are covered by FDIC insurance and, at credit unions, by NCUA insurance. Both of these protect each individual account holder at the institution for up to $250,000 in deposit balances, should the institution fail. For most consumers, this more than covers what they have on deposit.

But if you are holding more than $250,000 in deposit accounts, you’ll want to split your balance across more than one account holder or institution.

The Bottom Line

Savings accounts offer one of the simplest ways to earn interest on the money you have. They offer higher interest rates than a regular checking account, while still making it easy to spend and withdraw money. However, savings account rates are much lower than other investments, and they don't keep pace with inflation.