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How to open an IRA

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Key takeaways

  • An Individual Retirement Account – or IRA – is a popular retirement savings account that is tied to an individual, not an employer. Opening an IRA is a pretty simple process. 
  • There are several different types of IRAs, but the two most common are the traditional IRA and the Roth IRA.
  • Within an IRA, you can decide how much control you want over your investments: options range from complete control (self-directed) to entirely automated (robo-advisors).
  • There are many choices when it comes to IRA providers, so make sure to do your research first. 
  • Once you’ve selected a provider and opened an account, you’ll transfer funds in, choose investments, and let compound interest do the work. 

Opening an IRA is one of the easiest things you can do to help secure your financial future. It’s important not to worry about how much you have to invest and to simply focus on getting started as soon as possible

 

The aim of this piece is to address some of the more basic IRA-related questions. Answering these questions will help you map out a plan to open the IRA of your choice. These questions include: 

 

  • Why should I open an IRA?
  • What types of IRAs can I choose from?
  • How much control do you want over your investments?
  • How do I pick an IRA provider?
  • How do I open and fund my IRA?
  • How do I set up my account and investments for success?

Keep reading to learn more! 

 

The first reason to open an IRA is to help you save for retirement. An IRA is a tax-advantaged account that provides a platform for investments to grow over time

Depending on your employment status, you can use an IRA as your primary account for retirement savings, or you can use one to supplement your employment-sponsored retirement plan (like a 401(k). The beauty of an IRA is that it can be opened, managed, and changed independently — this happens entirely outside of any formal employment, so everything is in your hands.

If you are leaving a job and you have a 401(k), you might consider opening an IRA. You have the option of moving your 401(k) to an IRA — commonly known as a “rollover”. A rollover to an IRA usually allows the owner more investment choices and greater control over their retirement savings.

IRA owners also get significant tax benefits. Depending on the type of IRA you choose, these benefits will differ. Additionally, your overall financial picture will determine the specific benefits available to you. An IRA can also serve as a consolidating account to allow you to see your retirement savings picture more clearly. 

While there are many types of IRAs, the two most common are the Traditional IRA and Roth IRA. Both are tax-advantaged, but in different ways.

A Traditional IRA is meant to give the account owner a tax deduction today in exchange for tax-deferred growth. What this means is that once money has been deposited and invested in your account, it will grow tax-deferred until the time of withdrawal. No tax is charged until money is actually withdrawn from the account, at which time the amount of the withdrawal is added to your taxable income for the year.

A Roth IRA operates under entirely different rules. With a Roth, you’ll pay tax up front when you contribute, invest the money, and then withdraw funds tax-free in retirement. A Roth IRA allows you to “lock-in” today’s tax rate in exchange for never having to pay tax again. For many people, a Roth is appealing because it allows you to remove your tax burden up front, giving your investments a chance to grow and be withdrawn without paying taxes.

With both types of accounts, there are eligibility rules, contribution limits, and income restrictions, so be sure to acquaint yourself with each type of account before investing.

If you’re more of the DIY-type, you have every opportunity to manage your IRA investments on your own – this is called a self-directed IRA. Most of the online brokerage platforms (think Fidelity, Vanguard, and Schwab) allow for free or extremely low-cost trading, so this is definitely a chance to go it alone if you’d like.

Specifically, some of the pros and cons of this route include:

  • Pros
    • Complete autonomy to choose investments
    • Free account opening
    • Free trading in many securities
    • Low-cost investments
    • Advice available if needed
  • Cons
    • Responsibility falls to account owner
    • May be intimidating to new investor

On the other hand, there are providers in the marketplace that offer automated investing (sometimes called “robo-advisors” — think Betterment, Wealthfront, and others). These platforms will select investments for you based on a list of variables and will periodically rebalance your account as time passes. While you won’t need to do anything once the account is established and funded, you will need to pay an ongoing annual fee (usually ranging from 0.25% to 0.50% of the account’s value) for the service.

Some of the benefits and drawbacks include:

  • Pros
    • Little action required beyond account opening
    • Typically use low-cost index funds
    • Hands-off approach encouraged
    • Eliminate user decision fatigue
    • Use robotic algorithms to maximize investment and tax efficiency
    • Planning advice available if needed
  • Cons
    • Typically have an annual cost of 0.25% to 0.50% of assets managed
    • Might create unnecessary complexity
    • Investments may not differ from ones easily chosen on your own

Which type of account you’d like depends on you. Consider how familiar you are with investing and how much time you’d like to spend maintaining your portfolio when picking between these options.

When it comes to opening an IRA, keep things straightforward. It’s very easy to open an IRA online, and once you’ve chosen a provider, it should take no more than 15 minutes to set up. Simply navigate to one of the online brokerage platforms and follow the prompts to open an account.

There are multiple ways to fund an IRA:

  1. Fund from your checking or savings account. This is as simple as it sounds, but realize you’ll only be able to contribute up to the IRS annual maximum. For people under 50, this amount is $6,000 for 2020 and 2021; for people over 50, the annual maximum is $7,000 for both 2020 and 2021.
  1. Complete a rollover of a former employer’s 401(k) plan. Say you recently left a job, and your old 401(k) plan is still active. You can roll over this money to an IRA opened at a custodian of your choice. Be careful to ensure that the tax treatment between the two accounts is the same to avoid any unnecessary tax liability.
  2. Rollover an existing IRA. Two of the best attributes about IRAs are their portability and convertibility. You can merge two traditional IRAs or two Roth IRAs with no tax consequence, but if you are to convert a traditional IRA to a Roth IRA, you’ll be responsible for taxes on the entire conversion amount.

Setting up your automated or self-directed account comes with some key decisions. Choosing investments depends on your personal circumstances, but generally speaking, you should try to select an asset allocation (and specific investments) that matches your risk tolerance and time horizon. You should consider your newly-created IRA as one account in the context of your total financial picture as opposed to a standalone account.

If you decide to self-manage your IRA, you’ll need to think about your overall asset allocation across all of your financial accounts. Within an IRA you’ll have the option to invest in stocks, bonds, ETFs, and mutual funds, but it’s a good idea to develop a diversified investment lineup to spread risk. Keeping investment expenses to a minimum is also critical.

If, on the other hand, you choose to hire an automated investment manager, the company you choose will make all of the investing and trading decisions for you. They’ll usually have you answer a questionnaire about your overall financial picture and your long-term expectations for the account. Typically, if you’re young, you’ll be guided towards a growth-oriented portfolio, but your provider will be responsible for keeping you on track as time goes on.

Opening an IRA is one of the more effective things you can do to secure a comfortable retirement. You have many choices as to which type of IRA you open first, so take care to understand the differences and limitations. Your IRA choices will also come with tax consequences, both now and in the future, so the sooner you learn about IRAs, the better!

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