Here’s a reality check: The days of receiving a full pension and medical benefits when you retire are a thing of the past.
When the time comes for you to stop working, the more retirement savings you have, the more financially comfortable your golden years will be.
Even during your prime working years, retirement accounts offer excellent tax benefits, allowing you to maximize both how much you contribute and how much these contributions grow.
There are several types of retirement vehicles to choose from, and one of the most popular types is an individual retirement account (IRA). This post explains what an IRA is, why you need one, how to set one up, and how to manage it.
Steps to Open an IRA
Opening an IRA may seem complicated if you are unfamiliar with the process, but it’s pretty easy to do.
- Determine Your IRA Account Type
- Select an IRA Provider
- Fund Your IRA
- Allocate Your Funds
- Manage Your IRA
1. Determine What Type of IRA Account You Want
For most people, there are two types of IRA accounts to choose from.
Traditional IRA Account
A traditional IRA lets you make pre-tax contributions to the account, which is one of the best tax advantages you can find.
In other words, you fund the account with tax-free money you’ve earned, and the money can grow on a tax-deferred basis until you access the money at retirement age. When you access the money, however, you will have to pay income tax on your withdrawals.
Roth IRA Account
When you set up a Roth IRA, your contributions are not tax-deductible, meaning that you have to pay income taxes on the funds before you deposit them. The main tax advantage of a Roth IRA is that you can avoid paying taxes later in life when you go to access the money in retirement.
Simply put, Roth IRAs are funded using post-tax money, and you can make qualified withdrawals on a tax-free basis.
Roth vs. Traditional IRA: What’s the Better Option?
A Roth IRA has income limits, so not everyone qualifies. The gross income limit for a Roth IRA in tax year 2020 is $139,000 for single filers and $206,000 for joint filers. For the tax year 2021, those limits will jump to $140,000 and $208,000, respectively. Traditional IRAs do not have income limits.
If you’re eligible for both types of IRAs, the next step is to determine if you’ll be in a lower tax bracket at retirement age. If this is the case, you may want to take the traditional IRA route. On the other hand, if you anticipate being in a higher bracket at retirement, it may be better to take the Roth IRA route and pay income taxes now.
Either way, don’t stress too much about which option you pick because you can always change course down the line by doing an IRA rollover. Also, don’t hesitate to ask your tax advisor about which direction makes the most sense for your situation. This is common territory for most financial professionals.
2. Select an IRA Provider
The next step is deciding which financial institution to trust with your IRA account.
The most common way to do this is through a brokerage firm (e.g., Vanguard, Blackrock, Fidelity, TD Ameritrade, or Schwab).
Using your brokerage platform, you’ll be able to easily view your account at any time through its website or mobile app. You can also make investment choices and monitor your funds’ growth over time.
Traditional brokerage accounts are great places for hands-on investors who want to have full control say over where their IRA investments are allocated.
If you prefer to sit back and let algorithms control your IRA investments, then a robo advisor IRA account could be a good option. Your account will be fully-automated, meaning that you don’t have to worry about rebalancing or adjusting your investment options.
If you take this route, make sure that the asset under management fees are no more than 0.40%, which is pretty standard among the leading robo advisor accounts.
Bank or Credit Union
You can also open an IRA through your local bank or credit union. For example, most of the big national banks offer IRAs, such as Bank of America, Chase, and Wells Fargo. As do most large credit unions, such as Alliant.
However, I only recommend investing with a bank or credit union IRA if your primary goal is long-term savings (as opposed to long-term growth). By far and large, the best way to grow your IRA account is by investing it in the stock market through a brokerage firm or robo-advisor.
3. Fund Your IRA
At this point, your account is ready to go and you have a clear course of action. The next step is funding your account.
Here are the common ways to fund an IRA.
Check or Electronic Transfer
The easiest way to fund an IRA is through a check or electronic ACH transfer from your checking account or savings account. Simply link your bank account to your IRA provider and follow the instructions. You may have to wait two or three business days for the funds to clear.
If you already have a retirement account from a current provider, but you want to move over to a new one or consolidate, you can rollover your funds to a new account.
I recommend asking for guidance from your IRA provider during the rollover process to ensure you don’t encounter any problems. For example, the last thing you want to do is make a mistake and wind up having to pay a tax penalty or early withdrawal penalty.
IRA Contribution Limits
One of the downsides to an IRA is they come with contribution limits. The IRA contribution limit for tax year 2020 is $6,000, and this applies to traditional and Roth IRAs.
If you have enough money to maximize your contributions, this approach is recommended. If you have money leftover after maximizing your contributions, I recommend putting it into another tax-deferred vehicle (e.g., your employer-sponsored 401k) or another investment account so that it can grow.
4. Allocate Your Funds
Once you transfer money into your retirement account, the next step is to allocate your funds into various investments — a process that can be somewhat difficult if you’re new to investing.
At this point, it’s a good idea to determine your risk tolerance, or your ability to withstand the numerous downturns that you’ll face in the market. If you’re in your 20s, 30s, or 40s, you’ll have plenty of time to absorb risk and bounce back from bad investments and market downturns, so it may be advantageous to allocate a large portion of your portfolio to equities.
Here are some of the various investments you can make in your IRA.
Investing in individual stocks is necessary for driving growth. However, stocks are also somewhat volatile and expose you to risk.
Consider going with the 60-40 approach, where 60% of your portfolio goes toward stocks and 40% goes to funds. So if you max out your IRA at $6,000, put $3,600 into individual stocks.
One approach is to pick a handful of companies with proven track records and spread the $3,600 equally among them. If you want to buy a stock that costs more per share, consider buying fractional shares and reinvesting your dividends to work up to full shares.
It’s also a good idea to spend some time thinking about why you are investing. After all, there are thousands of publicly traded companies in the U.S. and so you have to be highly selective. Look for companies that you know and trust, and which are likely to produce strong gains as time goes on. As the saying goes, the best stock is the one you never have to trade.
After you allocate 60% of your funds to stocks, take the remaining $2,400, and diversify your assets.
Mutual funds pool money from numerous investors to buy collections of securities. For example, a mutual fund may contain a mix of stocks, short-term debt, and bonds. Mutual funds typically have portfolio managers and are actively traded — meaning they attempt to beat the market instead of tracking it.
Keep in mind, though, that fewer than half of actively managed funds beat the market when you take fees into consideration.
Exchange-Traded Funds (ETFs)
ETFs are similar to mutual funds because they are built around baskets of securities. However, ETFs are bought and sold like stocks throughout the day like stocks and their prices fluctuate.
ETFs are usually passive in nature, meaning they track markets and don’t have portfolio managers.
Index funds are a type of fund that tracks a specific index (e.g., the total US stock market). They are almost always passively managed.
Index funds can provide steady returns over many years, making them a great fit for young investors who are looking to maximize earnings while diversifying and reducing risk exposure.
5. Manage Your IRA
Once your IRA is set up and funded, it shouldn’t require any daily maintenance. Since this is a retirement account, the goal is to plan for long-term growth (as opposed to making frequent trades in an effort to win short-term gains, which is a strategy that loses more often than not).
Going forward, there are two important tasks that you must remember each year. The first is to keep funding your IRA until you maximize your contributions. Depending on your cash flow situation, some people prefer to contribute on a monthly or weekly basis, while others prefer to put one lump sum in at a time.
The other task that you should do is to periodically rebalance your IRA. Many accounts allow for automatic portfolio rebalancing, which is a feature that most people should select. There is also a general rule of thumb that you should rebalance your portfolio when your asset allocation changes by 5% or more.
Frequently Asked Questions
Should I open a brokerage account in addition to a retirement account?
For most people, yes. Most investors have goals they want to reach before retirement age. Using a brokerage account can help provide accessible income that you can tap into before you reach age 59 ½.
This strategy is very useful for people who are planning an early retirement. For example, suppose you want to retire at age 50. You’d still have 9 ½ years before you can access your IRA funds without being penalized by the IRS, and most likely even longer until your Social Security benefits kick in.
Funding a brokerage account won’t provide any immediate tax benefits, but it’s the best way to grow your income. Plus, there are no annual contribution limits, so you can put as much money as you are comfortable investing to maximize growth. Just make sure to fully educate yourself about what you are investing in before diving in and don’t invest any money that you can’t afford to lose.
Can a financial advisor help with an IRA?
A financial advisor can help ensure you’re allocating money into the right areas and planning correctly for retirement. This is particularly important as you get older, and you start transitioning away from equities to reduce risk. An advisor can also provide tax advice.
What is a time horizon?
A time horizon is a period of time that you plan to hold an investment. When you open an IRA, you should expect to hold that money until age 59 ½, which is when you can touch the money without paying taxes or penalties.
Should I put my stimulus check into an IRA?
Putting your stimulus check into an IRA is an excellent way to grow your money for retirement if you are in a position to do so. Keep in mind though that stimulus checks are not taxable, which means you can freely invest it without having to give any money back to Uncle Sam.
The Bottom Line
The bottom line is that setting up an IRA could be one of the best investment decisions you ever make. It’s also very easy to do and something that all investors should consider.
As one final takeaway, remember that retirement does not have to be some far-off initiative that you reach when you are no longer capable of working. A growing number of investors are choosing to put more money aside to retire earlier and obtain financial freedom while they are still young and healthy.
Challenge your preconceptions about retirement, and analyze your situation to see if there is more you can do to get ahead. With a robust and multi-faceted retirement plan, you could potentially reach your financial goals a lot sooner than your peers.