Which Offer Better Rates, Traditional Savings Accounts or IRAs?

The question of comparing rates between a Traditional Savings Account and an IRA is, at first glance, like comparing a horse and a cow, or more familiarly, an apple and an orange.

The traditional savings account option is an after-tax, all-in, existing rate-of-interest investment. A traditional IRA is a tax-avoidance investment intended to build a retirement nest egg that you may choose to diversify across more than one investment vehicle, all of which would naturally yield different rates of return. And, as it happens, one option for all or part of an IRA could be an IRA savings account.

So, rates of return notwithstanding, let’s examine the tax situation first. Today a traditional savings account would yield between 0.25% to, say, 1% per annum. Thus, at the end of a year, an investor of $100 would yield a whole $.25 to $1.00. All interest accruing in a savings account is taxable and must be claimed as Interest Income. Upsides to a traditional savings account, however, are that your money 1.) may be withdrawn at any time without penalty and 2.) is currently insured by the Federal Deposit Insurance Corporation (up to a certain value). Thus, there’s very little chance of losing your principal.

That is pretty straight forward.

An Individual Retirement Account has many more complexities or “moving parts”. The IRA is comprised of contributions of funds that will not be taxed in the year earned and is deducted from your Taxable Income at tax time. Simply put, an individual whose gross salary is $100,000 might make a $5000 IRA contribution, thereby reducing his taxable income to $95,000. Without consideration for other deductions, this alone can be a tax savings of several hundred dollars in that particular year. Only later, after the age of 59 ½, will the withdrawal of the principal and earnings be taxed. This is presumed to be at a time when normal earnings are reduced or eliminated and typically expenses are lower. But note that earlier withdrawal will result not only in the payment of taxes on the amount withdrawn but also a substantial penalty.

As for investments in an IRA, the universe is almost unlimited. You might choose a self-managed IRA which would allow portfolio choices that include a mix of stocks, bonds, mutual funds, ETF’s and even CD’s and IRA Savings Accounts, among others. Some companies offer ‘Target Date” mutual funds that gradually modify investment strategies, rebalancing toward less risk as the investor approaches retirement.

Since 1960, traditional savings accounts in the USA have yielded an average of about 6%, which includes some double digit years in the 1980s.

In the same time period, the S&P Index for stocks has yielded annualized increases through 2013 of 11.58% including some very negative patches in 1974, 2001 and 2008, during which a traditional savings account would have been a better choice…if you had a talent for reading the future. Most of us do not.

So, in the end, a choice between investing in a Traditional Savings Account versus an IRA depends primarily on when the money is needed rather than the specific yield. If the funds are intended for a specific purpose within a relatively short time, then a traditional savings account would be the better answer. If the money can be put away for a long period and achieve the tax deferral benefit and likely better yields as a result, then an IRA is far better.