Not all retirement accounts are sponsored by our employers.
There are a few reasons that we might consider opening an IRA.
In this post, I will go over the 2 main types of IRA accounts, when to consider opening them, what you can invest in, and how to fund your IRA.
IRAs…Who Needs Them?
While many employers offer 401k or 403b accounts, with many automatically enrolling their employees and/or offering a non-discretionary contribution amount, an IRA tends to be a more self-motivated investment vehicle. Before you venture into opening an IRA account, there are some things to consider. Are any of the following statements true for you?
- I am a hands-on/do-it-yourself kind of investor.
- This will basically follow my guidelines for investing in individual stocks from my last post. If you are a “yes” for individual stocks, you are probably also a “yes” here.
- I will be working with a fiduciary* financial advisor.
- *Fiduciary means your advisor is working in your best interest and not just trying to sell you a product in order to collect a commission.
- Preferably, your financial advisor will either have some letters after his name or be working towards that goal. (CFP is common. A CPA can add some tax expertise.)
- Working with a good financial advisor will help take a lot of the guess work out of picking a good portfolio to build in your IRA account.
- My employer does not offer a 401k/403b retirement account.
- If you don’t have access to a retirement account through an employer (to be safe, I wouldn’t rely solely on a pension if you have one), an IRA can help in getting your plans for your future self going.
- If this is you, you might also want to consider point number 2 about enlisting the services of a financial advisor.
If none of those statements were true for you, you may want to stick with your 401k/403b and work toward maximizing your contributions there. Contributing generously to an employer-sponsored retirement plan can be great by itself.
If any of the above 3 statements apply to you, an IRA could be in your future.
Regardless of your situation, let’s continue.
Types of IRA Accounts
There are 2 types of individual IRAs available for us regular folks, the Traditional IRA and the Roth IRA. Where you should be elsewhere in your financial life before opening one of these IRAs depends on the type of account you choose and whether your employer sponsors a retirement account such as a 401k or 403b.
This post isn’t meant to go into a detailed comparison of these accounts; that comparison is all over the internet in places like Investopedia. What follows is just my opinion, and should not be considered advice. This is my take based on what I think would work for me.
I’ll start with the Roth IRA because that’s the direction that I ultimately went.
You contribute to a Roth IRA with a portion of your after-tax income (take-home pay) and the contributions are not tax deductible. The good news is that, as long as you follow the rules, you will not pay any taxes on the money you earn in, and withdraw from, this type of account. The best I’ve heard it phrased is that a Roth IRA puts your taxes in the rear-view mirror. The catch is that there are income limits that determine if and how much you can contribute to a Roth IRA.
Before you open a Roth IRA, here are the housekeeping items I think you should have out of the way:
- Good Money Habits: You have an income and spending plan such that you are earning more than you spend each month.
- Emergency fund savings of at least 3 months of expenses.
- Savings of one and a half months AND you are contributing 5-10+ percent of your take-home pay toward the emergency fund to sustain and increase the balance is also OK in my opinion.
- All revolving debt (credit cards) are paid off.
- As with individual stock investing, a mortgage is allowed. Low interest (3% or lower) balances on student and auto loans we’ll call a maybe. Keep in mind that the higher your debt payments, the more financial stress you’ll feel from as you contribute to an IRA.
- You are contributing to your 401k/403b such that you have, at least, maximized your employer’s matching contributions.
- If you’re employer does not offer such a plan, I will let you skate on point 3 about the credit cards, but limit your IRA contributions to 2% of take-home pay until you get those debts behind you.
Strictly by the numbers, a Roth makes the most sense early in someone’s career when their earning power is lower and it’s more likely that their tax rate will be higher in retirement than it is today. Later in your career, you will have, hopefully, increased your annual earnings and it becomes more likely that you are paying a higher tax rate in those years than in your retirement years.
In the end, it’s all a guess really. So, I decided to go with a Roth even though I am entering my late 40s. I wanted some of my retirement money to be tax-free. I believe the fancy term for this is “tax diversification.”
The other type of IRA account is the Traditional IRA. Investopedia describes the Traditional IRA as the opposite of a Roth.
Your contributions to a Traditional IRA may be tax deductible, and limits are based around your age (you must be younger than 70 1/2 to contribute) rather than your income to contribute to this type of account.
The “housekeeping” items I listed as my personal prerequisites to opening a Traditional IRA are the same as for a Roth, except for one item:
- You should be contributing the maximum amount that YOU are allowed to contribute annually to your 401k/403b if you have access to such an account.
- $19,500 in 2020 (younger than 50); $26,000 in 2020 (50 years and over)
- Because the Traditional IRA functions a bit like a 401k, anyway, maxing your employer-sponsored retirement account before moving on keeps things much simpler in terms of what funds you are investing in and how many accounts you are maintaining.
The Last Bit of My Opinion
As I said earlier, I opted for the Roth IRA. I plan on continuing in the Roth until I get closer to the income limits that would prohibit me from contributing directly to a Roth IRA. I figure, at that point, I can enlist the services of a financial advisor to walk me through the finer points of super-charging my retirement plans.
As you process that previous paragraph, keep the following 3 points in mind:
- I am not a financial advisor.
- I am not an accountant.
- Most importantly, I am not you.
What Will You Invest In?
(And, Where Will You Do It?)
After you’ve decided which type of IRA is best for you, the next step is to decide where you will open your account and what you will invest in.
You should have an idea, generally speaking, of what you want to invest in. Unless you have a 401k, and simply want to invest in the same options you chose there, you don’t need to know the EXACT investments you’ll be purchasing.
When I say general idea, I mean that you know enough to ask certain questions should you need some guidance as you’re deciding on the “where” part of the equation. The main options, from what I consider simplest to most complex are:
- Target-dated funds – Pick the target date closest to your planned retirement date or retirement date + 5 years.
- Mutual Funds and Exchange-traded funds (ETFs)
- You can mirror the mutual funds in your 401k/403b if you want.
- Note that if any of your 401k/403b selections have “CIT” or “CIF” (Collective Investment Trust/Fund) in the name, they will NOT be available for your IRA. (See bullet point about “financial advisor” in this section.)
- ETFs are also not usually used in 401k/403b accounts, but there are a lot to choose from. (see next bullet point.)
- You may want to speak to a fiduciary financial advisor, or contact the brokerage where you decide to open your account for help making your mutual fund/ETF selections.
- Individual Stocks and Bonds – make sure you’re willing to do the work, if you try this.
Once you’ve got things narrowed down to the general ideas listed above, you’re ready to decide where to open your account.
Just about any brokerage out there will offer a wide array of investment choices for you to choose from. What it will likely come down to is which one of these brokerages will meet your needs in terms of your financial plan and automating the purchase of your investments. Some options include Schwab, Fidelity, and Vanguard. (I use Schwab.)
If you’re leaning toward individual stocks or target-dated funds, you probably have an idea of where you want to start.
But, the immense number of options available in mutual funds and ETFs can be paralyzing without a little help. Don’t hesitate to contact a brokerage (if you are not using a fiduciary financial advisor) before opening an account. Some things you may want to ask about are:
- What is available to help me choose my investments? If so, are there any fees (other than those reflected in the funds’ expense ratio) associated with these services.
- Online tools?
- One-on-one personal assistance?
- Is there an automated investing feature available so I don’t have to manually purchase my investments every time I make a deposit into my account? If so, are there any fees associated with this service.
Funding Your IRA Account
Why do I have a section about putting money into your account? Isn’t that the easy part?
Yes, that is the easy part. Sort of.
My intent here is to put some method to the madness, so to speak.
For 2020, the maximum contribution into IRA accounts is $6,000 if you are under the age of 50, $7,000 if you are 50 and older. These numbers bring about 2 main issues.
Don’t Let the Perfect be the Enemy of the Good
You may run into the same issue I have had in the past. You see that $6,000 figure above and figure that, if you can’t invest the max, you won’t invest anything. I want you to avoid this way of thinking.
But, if you’re on the fence and you’re not sure what you’ll be able to invest and for how long, you can open a discretionary SAVINGS account as a trial run. As a rule of thumb, I start with 2% of take-home pay as a deposit into any new account to test things out. Deposit your 2% into savings for 3-6 months and see how it goes. If all is still well after your test period, open your IRA and start transferring the money from savings to IRA. After the initial deposit, set up a monthly transfer and get the investments going.
The main thing to avoid here is to not invest because you can “only invest” a portion of the $6,000 figure each year. Even if you start with a small amount, it can make a difference in the long run.
Don’t Overdo It; the IRS Will Get Mad
If you’re in a situation where you feel that you will definitely be able to max out your annual contributions, you just want to make sure set up a system to make sure you don’t contribute too much. The IRS doesn’t like it when you sock away too much money in tax-advantaged accounts.
The easiest thing to do is probably to set up a discretionary savings account like we did in the section above. For this situation, we simply set up a monthly transfer of up to $500; $500 x 12 = $6,000 for the calendar year. If you’re over 50, the monthly deposit into your IRA would be up to $580 to get to $6,960…just shy of your $7,000 limit for 2020.
(If you decide to open a Roth IRA, make sure you adhere to the maximum contributions dictated by the income limits for each year you contribute.)
And, that’s about it.
Actually, this post ended up a lot longer than I thought it would. But, hopefully, you found at least some of it useful. And, rest assured that I’m learning right along with you as I write this stuff down.
Until next time. Thank for visiting Finunciate. Come back soon.