Even if you're young, contributing to an individual retirement account is a basic financial decision, because it can affect your entire future. Traditional IRAs allow you to make tax-deductible contributions and sock that money away tax-deferred. You only pay taxes on the cash you take out of the account. You don't have to begin withdrawing the money until you hit age 70 1/2. You can invest your IRA contributions in a variety of things, including stocks, bonds, mutual funds and cash reserves.
If you open an IRA at a mutual fund company or brokerage, you may automatically receive a core account, known as a money market or cash reserves account, to hold your cash. Cash reserves accounts invest your cash in short-term securities called money market instruments and repurchase agreements. Each share of the account is worth $1, and the account provider, normally a mutual fund company, manages the account to keep the share value from changing, though this is not guaranteed.
Cash reserves accounts offer safety and convenience. They are safer than most other investments because they limit their purchases to fixed-income securities that mature in days or weeks. Some accounts allow you to sweep the balance into interest-bearing accounts at a participating bank. The Federal Deposit Insurance Corporation insures the swept funds. A mutual fund company also normally provides private insurance from the Securities Investors Protection Corporation for cash amounts up to $250,000, in case the fund company fails financially. Such insurance doesn't prevent cash reserves shares from "breaking the buck," or falling below a price of $1 per share.
Your other accounts held with the same IRA custodian link to your cash reserves account. In this way, you can use cash reserves to buy mutual fund shares. You can also use it to hold the proceeds from the sale of mutual fund shares, while you decide where to invest the money next. Your IRA custodian may allow you to link your bank account to your cash reserves account to allow easy transfers between the two. If you wire money from your IRA cash reserves account to your bank account, you'll have to pay taxes and perhaps penalties on the amount unless you roll it over into an IRA within 60 days.
Your IRA custodian might be a brokerage company. A cash reserves account at a brokerage is versatile because you can use the money to buy shares from a variety of mutual fund providers. You can also use it to buy stocks, bonds, exchange-traded funds and other investments. You can deposit interest and dividends into your cash reserves account automatically, if you don't choose to reinvest them in your mutual funds. While convenient and safe, cash reserves account might pay little interest.
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