IRAs are a powerful resource in helping you reach your retirement savings goals. While these tax-advantaged accounts may seem complicated at first, the basics are much easier to understand than you might think.
What is an IRA?
An individual retirement account, or IRA, is a type of investment or savings account that comes with tax benefits to help you save for retirement. The specific tax benefit depends on the type of IRA: Roth, traditional or nondeductible.
For many people, retirement planning begins and ends with their employer’s retirement plan, often a 401(k). But 35 percent of private-sector workers don’t have access to an employer-based plan, according to The Pew Charitable Trusts. That leaves many people on their own to save for retirement, and an IRA account is the perfect starting place.
The annual contribution limit for an IRA is $5,500 for 2017, and $6,500 for savers over 50 years old.
Who can open an IRA?
Anyone with an income can open an IRA. Nonworking spouses also can open IRAs as long as the household’s taxes are filed jointly.
There are three basic types of IRAs available to individuals:
- A traditional IRA offers a tax deduction for the tax year in which the contribution was made.
- A Roth IRA gives investors the chance to invest money after taxes and then take the contributions and earnings out tax-free in retirement.
- A nondeductible IRA is generally the only alternative for very high earners who otherwise don’t qualify for the other types.
Both deductible IRAs and Roth IRAs have income thresholds that govern who can make qualified contributions to the accounts.
“If it is deductible, you take (the amount of the contribution) off your income. The disadvantage is that when it comes out, you have to pay tax on it,” says CFP professional Herbert Hopwood, CFA, president of Hopwood Financial Services in Great Falls, Virginia.
Contributions to Roth IRAs are made after taxes are paid, so there is no deduction. Instead the contribution grows tax-free.
“There aren’t many things in life that are free, but the idea is that you put money in and as long as you wait until 59 1/2 years, all of the earnings come out tax-free. That is a huge benefit, especially when someone is young, because the money could compound and it could be worth 10 times what they put in or more,” Hopwood says.
When should I start?
Start contributing to an IRA in the womb if possible, if you’re able to verify income. Failing that, start as soon as you get your first job. If that ship has long sailed, start now.
“If you started at 20, contributing every year … and then you stopped at age 30, at 60 you would have more money than someone who started at 30 and contributed regularly for 30 years,” Hopwood says.
Where do I get an IRA?
IRAs can be opened at most financial services providers, online or in person. That includes local banks and credit unions, brokerage firms and big mutual fund superstores or discount brokerages.
Though there are advantages and disadvantages to service providers, new savers should look for ample resources made available to investors, such as online educational materials and in-person guidance.
Questions to ask providers:
- What are the fees for the account?
- What kind of guidance or advice is available? How much does it cost? How are advisers paid?
- What types of investments can be held in the account?
- What are the trading costs?
How should I invest?
Investing is typically a big hurdle for retirement savers. It can be a daunting and bewildering topic and takes a lot of homework to get up to speed.
Ideally, people with a long time until retirement will invest in the stock market. Investors with 10 or more years until retirement can afford to take on more risk and go for the high returns offered by the stock market rather than playing it safe with certificates of deposit and Treasury bonds; you can’t lose money in very safe investments, but you can’t earn much either.
The easiest solution to the investing dilemma? Go with a total market index fund to get the ball rolling.
A total market index fund offers instant diversity, which mitigates many of the risks inherent in the market such as specific company risk or geographic risk. Those risks crop up when just one or two companies — or even just one country — account for most of a portfolio.
Consistent saving coupled with a reasonable rate of return over a long period of time could put you in the millionaires’ club. At the very least, it will help you pay the bills in retirement.