Whether you are new to investing or are a seasoned pro, the safety of your retirement investments is an important factor in determining how much money you’ll end up accumulating for your golden years. You might not want to risk losing any of your investment money but being too risk-averse can sentence you to low returns that lag behind inflation. This tradeoff adds nuance to the question of money market account safety.
What Is a Money Market?
Normally, many types of institutions, including banks, financial companies, pension funds, corporations, hedge funds and governmental agencies, have fluctuating amounts of excess cash that isn’t tied up in long-term investments. Rather than letting the extra cash sit idly, institutions lend it out for short periods in order to earn interest. The money market is an umbrella term that refers to a variety of short-term loans, such as certificates of deposit, treasury bills, commercial paper, repurchase agreements and other securities that mature in one day to one year. You, too, can earn interest lending your cash to the money market by opening a money market account at your bank or a money market fund at your broker or mutual fund company.
Money Market Accounts vs. Funds
Banks and credit unions offer money market accounts to savers who want to earn a smidgeon more interest than available from a plain-vanilla savings account, even though money market accounts frequently require higher minimum balances. At banks, these accounts are insured by the Federal Deposit Insurance Corporation, whereas the National Credit Union Administration insures credit union money market accounts. In either case, each account is insured against losses of up to $250,000. If you keep money market accounts at several banks, each account will be separately insured for $250,000.
Usually, money market funds, which are sponsored by brokers and mutual fund companies, serve as temporary parking spots for money that is awaiting investment elsewhere. Your fund shares are also insured for $250,000 by the Securities Investor Protection Corporation, but only against losses stemming from financial difficulties of the fund sponsor, not against losses suffered by the underlying securities in the fund. Such a loss can cause the fund’s shares to fall below $1 each, an event known as “breaking the buck.” If the account sponsor chooses not to make good on the $1 share price, you could lose money when the buck is broken.
Some folks confuse money market accounts with CDs. To clarify, your money market account might own various CDs in its portfolio, but you can’t specify which ones. You can instead purchase a CD from the bank sponsoring your money market account, but the CD is held separately from your money market account. You earn IRA CD rates if you hold CDs in your IRA.
What Is a Money Market IRA Account?
Your bank or credit union can open a money market IRA account for you without much fuss, even if you own other IRA accounts elsewhere. The account is a traditional or Roth IRA that invests your contributions in money market instruments, not stocks, bonds or other riskier securities. You earn interest on the balance in your account, usually compounded daily and credited monthly. Some banks offer higher money market rates, expressed as an annual percentage yield (APY), for accounts with larger minimum balances. Except for the fact that your money market IRA account is insured against loss and is limited to investing in money market instruments, the account functions just like any other IRA.
How Traditional IRAs Work
An IRA, or individual retirement arrangement, is an account devised by Congress to encourage you to save for your retirement. A traditional IRA lets you deduct your annual contributions from your taxable income, and you don’t have to pay current taxes on any earnings your IRA enjoys. As of 2018, you can contribute $5,500 a year to IRAs, or $6,500 if you’ve reached age 50.
Eventually, you will pay taxes when you withdraw money from your traditional IRA. You must begin taking required minimum withdrawals each year starting at age 70 ½. The required withdrawal amount is determined by your age, possibly the age of your spouse and your life expectancy as estimated by the IRS. Withdrawals are taxed as ordinary income at your marginal tax rate, not as capital gains. If you distribute money from your IRA before reaching age 59 ½, the IRS might slap you with a 10 percent penalty tax on the withdrawn amount, unless you withdraw the money for one of a limited number of reasons that are exempt from the penalty. For example, the penalty is waived if the withdrawal is due to a disability, high medical bills, education costs, the death of the account owner, annuity payments and certain other reasons.
The Roth IRA Alternative
You can have your bank open a money market account as a Roth IRA, which operates differently from a traditional IRA. Contributions to a Roth IRA are post-tax (i.e., they are not deductible), but you can withdraw your money tax- and penalty-free if you follow the rules. Those rules state that you can withdraw contributions tax-free at any time but will pay taxes and a 10 percent penalty if you withdraw earnings during the five years following your initial contribution. You’ll also pay taxes on earnings withdrawn before age 59 ½ and may also pay a penalty if the reason for the withdrawal doesn’t qualify for an exception. Unlike traditional IRAs, you never have to withdraw money from your Roth IRA for as long as you live, and your beneficiaries receive their bequests from your Roth account tax-free after you die.
Safety and Risk
An insured money market IRA account is about as safe an investment as you can find, as long as you define safety as protection from loss. An IRA that invests in stocks, bonds or other risky assets is vulnerable to losses, especially during a market crash. That’s the price you pay for the superior long-term performance of these other assets. But safety in terms of investment losses is different from a risk-free investment. Even a money market IRA account is subject to certain risks:
Inflation risk: Inflation is the general rise in prices over time. Inflation robs your savings of its buying power, and one reason you receive interest on your savings is to combat the effects of inflation. However, there have been many times in American history when inflation was high. During high inflation, the meager interest you earn from your money market account can cause you to lose buying power. To address this risk, many investor purchase stocks because their prices usually benefit from inflation. Thankfully, it’s not an all-or-nothing decision because you can own multiple IRA accounts. For instance, you might have a money market IRA account at your credit union and another IRA account at your brokerage.
Creditor risk: Some states limit the protection from creditors your IRA will receive. Each state sets its own rules: Some limits are based on a dollar figure, others offer protection to the extent you need the IRA assets for reasonable support. If you are concerned about this risk, you might consider rolling over your IRA to a 401(k) account, which offers superior protection from creditors.