Open a Retirement Account: The Basics
If you’re young and new to the world of retirement investing (or if you’re not young and still new), we’ll spell out some terms and get you on your way to understanding the basics of how to open an IRA account and where to get started.
Common Retirement Accounts
Three of the most common retirement plans are the traditional Individual Retirement Account (IRA), the Roth IRA, and your employer-sponsored 401(k).
If you’re currently employed, and your company offers a 401(k), take advantage of it! More often than not, they offer to match your contributions dollar for dollar up to a certain amount.
That’s free money. If you can only swing $100 deductions out of your paycheck at first, then do it. Work up to more when you can. For now we’ll focus on IRAs. More on 401(k)s in another post.
Types of IRAs
The two most common IRAs are the traditional and the Roth. A traditional IRA is funded with money before it’s taxed. The Roth IRA is funded after your money is taxed. Both must come from a source of verified income. You’ll have to decide what’s right for you in choosing which IRA account to open.
You can open one of each as long as you stay within the max contributions (combined) allowed each year by the IRS. As of 2018, the max allowable contributions for the year is $5,500 for people under 50. That limit applies to one IRA account, or between both of them if you decide to open one of each.
Open a Traditional IRA — Pros and Cons
Pros of a traditional IRA Account
- It’s taxed at retirement, so if you think you’ll be in a lower tax bracket by then, this could be an advantage
- There are hundreds of investment choices (as opposed to your employer 401(k)
- Contributions are tax deductible (if income is $56,000 or less if you also having an employer-sponsored retirement plan)
- There are no income limits to open an IRA account
- You can pass it on to family after your death
- You can have an IRA in addition to other retirement accounts
Cons of a traditional IRA Account
- If you’re in a higher tax bracket at retirement, you’ll be paying out more taxes when you withdraw it
- Mandatory withdrawals starting at age 70 1/2
- No further contributions to the account after age 70 1/2
- There is a cap on how much you can contribute yearly (IRS caps at $5,500 for under 50)
- The contribution money must be earned income (proven by W-2 or similar)
Open a Roth IRA — Pros and Cons
Pros of a Roth IRA Account
- Most flexible retirement plan as far as having access to your money
- Contributions are already taxed so you’ll never pay out anything at retirement
- It offers hundreds of investment choices
- You can withdraw any amount you’ve contributed to the account (excludes interest earned) before retirement age — the money is available to you for emergencies etc. with no early withdrawal fees
- No forced withdrawal age
- You can continue contributing to this account at any age
- You can pass this money along to family after death
Cons of a Roth IRA Account
- You can only contribute up to $5,500 per year (as with a traditional IRA)
- If you make over a certain amount of income, you can’t open a Roth IRA straight out (you may be able to roll over a different retirement account into a Roth IRA (see IRS guidelines here)
- You can’t claim any tax breaks on your contributions each year since the money has already been taxed
- The money you contribute must be from earned income (need W-2 or similar to prove income)
- Added temptation to withdraw from this account due to no fees for early withdrawal (excluding interest earned) which can interfere with earning interest and growing your wealth for retirement
Which Investment Personality Are You?
When it comes to deciding which specific investment tools you want to use for your IRA account, it’s good to assess how involved you want to be. If you like to dabble in things and be involved with the process then you’re most likely a “hands-on” investor.
If money, finances, and investing makes you anxious, but you’re still wanting to do the smart thing and save for retirement, you are most likely a “hands-off” investor.
What is a Hands-On Investor?
First let’s clarify: hands-on investing seems to imply that you need to know the stock market and you’ll be actively involved in growing your money each day (at least that’s how it sounded to me when I first heard the term).
Hands-on investing isn’t the same as “day traders” or people who buy and sell throughout the day (or on a frequent basis) trying to maximize profits and beat/predict the stock market.
Hands-on investors simply want a say in where their money is going — how it’s split into various avenues of earning potential etc. These personalities like to do-it-themselves and enjoy choosing some of the investment vehicles and varying levels of risk related to those choices.
Great Investment Options for Hands-On Investors
IRA accounts invested in mutual funds are always a great idea. Mutual funds offer more choices than you can count as far as how to divide your investment funds among shares of large companies, small companies, international companies etc.
Here are some top firms for beginners that offer hundreds of mutual fund choices with few management fees and plenty of no-load (no commission or sales fees when you trade or buy/sell your shares) options.
Vanguard — one of the granddaddys of the mutual fund world. They are dependable, have some of the lowest management costs, and they consistently perform above average with the interest earnings on many of their funds. They also have the distinct advantage of being owned by the shareholders who own their funds.
When they are profitable, that profit gets passed on to the shareholders and not some outside investors. The one caveat to investing in a mutual fund IRA with Vanguard is the minimum investment of $1,000. In my opinion, they are well worth saving up that $1,000.
Charles Schwab — also a great choice for mutual funds with hundreds of choices and some of the lowest fees in the investment industry. The great thing about Charles Schwab is you can start an account with no minimum investment.
Fidelity — offers over 3,700 no-transaction fee mutual funds. They offer great customer service and, though the minimum for opening a mutual fund is $2,500, they will waive that if you sign up for automatic deposits of $200 or more per month.
What is a Hands-Off Investor?
If you are more of a “set-it-up-and-forget-it” type who isn’t concerned with choosing how your investment funds are divided up, then you’re most likely a hands-off investor. People who dislike finances and don’t have time to watch over their accounts fit nicely into this category.
The good news is there are now multitudes of “robo-advisor” investment options. Investing via robo-advisors simply means that your investments are done with computer investment algorithms and not handled by people. They are much lower priced than human-managed funds.
Great Investment Options for Hands-Off Investors
Ally Invest is a powerhouse and well-known name in the robo-advisor world. They offer competitive annual management fees, great customer service, and automatic re-balancing of your funds depending on what goals you’ve set with your account.
The minimum investment amount is $2,500 (without incurring fees), and they make automated investing easy for beginners. Learn more about Ally Invest here.
Wealthsimple is also a great choice for robo-investing. They are popular for their socially responsible investment options; they prioritize companies that are low-carbon emission and clean-tech etc.
They require no minimum to open an account, and have no trading or portfolio rebalancing fees of any kind. Their management fees are also quite competitive. Click here for more about Wealthsimple.
Finhabits is a newer robo-investment firm on the scene. It’s great for beginners who have very little to invest upfront — they even have a $5 per month automated deposit offer (you can always opt for more — which is recommended).
They have a decent management fee of $1 per month for balances under $2,500 and their portfolios are very customizable according to your risk preferences. They also offer the whole investment process in Spanish — which sets them apart. Click here to check out Finhabits.
A Quick Word About Index Funds
It’s impossible to address everything a beginning investor would need or want to know. I highly encourage looking through resource sections of investment firms, as well as studying up with dependable resources such as Investopedia.
Index funds are well worth mentioning before we close up this post. These are rockstar mutual fund choices for beginners — or anyone who wants low-cost and consistent interest yields over the long haul.
Index funds are set up to mirror the index they follow (such as the big S&P stock market index); they simply own/invest in all the same companies as the stock market index they’re following.
You get the benefit of how a particular stock market index performs without the fees associated with a fund manager trying to beat the market. And history shows that following a stock index (owning index funds) is a great way of building wealth over time.
If it’s good enough for Warren Buffet, it’s good enough for me!
The most important thing about our talk on how to open an IRA account is this: No matter what type of investor you are, or where and how much you begin with — just get started.
Each day that passes with no retirement savings is a day that you miss out on free interest money and growing a secure future.
Related — Turn a $1000 Investment Into $2.6 Million: The Magic of Compound Interest
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