How an IRA Can Help You

You may remember from my 401k post that there are several good reasons to invest in an IRA (Individual Retirement Account). These include:

  1. Maximum Flexibility: Invest in anything, with any investment manager/bank
  2. Avoid Taxes: Gains in an IRA are not taxed like they would be in a regular taxable account, so you’ll pay the government less.
  3. Penalty-Free Contribution Withdrawals: You can withdraw the money you put in at any time without penalty (though you can’t withdraw the investment gains that have grown on that money). This is good thing, just in case you ever need that money (though please remember that the stock market is NOT the place for your emergency savings).

Let me walk you through some of the basics of your IRA.

What is it good for?

Your IRA is a great place to put your retirement savings, offering a huge amount of flexibility while saving you lots of money on taxes. It is a “wrapper” around an investment account that indicates the holdings in that account have special rules surrounding them. If you have no 401k, or your 401k is crappy, you want to put your retirement money in here first before putting it in any taxable investment accounts.

Can I contribute, and how much?

The maximum contribution allowed each year is $5,500 and this contribution must come from earned income (you must have earned the money you put in it at a job). You can only contribute the full amount to a Traditional IRA if you make less than $61,000 as a single person, or $98,000 as a married couple. If you choose the Roth option, you can only contribute fully if you make less than $114,000 per year as a single person, or $181,000 per year as a married couple. After these income limits, the amount you can contribute quickly shrinks to nothing. As a side note: if you want to contribute to a Roth IRA and you make more than those limits, look into something called a “Backdoor Roth IRA”. It allows you to avoid these limits and continue contributing at any income.

You can contribute at any time throughout the year until April 15th of the following year. That is to say, if you want to contribute toward your 2014 IRA, there is still time! Once you’re past the deadline for a given tax year, you can never get that $5,500 of available tax advantaged space back, so do your best to contribute what you can for the earliest year possible!

How do I open one?

Find an investment brokerage (Fidelity, Schwab, and Vanguard are popular, I recommend Vanguard because it has the lowest fees, that’s what I use). Go to their website and open an account, pretty much like you would a bank account. You’ll have to choose what to invest your money in. If you’re not sure, check out the tips in my 401k post. If you’re still not sure, put it in a Target Retirement Date fund like this one (be sure to pick the one with the date closest to when you think you’ll retire). These are relatively low-fee, so you’re not paying much to have them handle things for you, but are very hands-off, so you can safely stick your money in there and not worry about it too much. They gradually adjust the amount of stocks vs bonds so you won’t be in too risky of a position come retirement. If you’re totally clueless, start there, and you can always go back and trade out for a different fund when you come back and are more educated about your options in the future.

Most banks offer an auto-withdrawal feature where they’ll automatically pull a set amount from your checking account each month to save for retirement. If you think this will help you stay on track or manage your money, look into it! Otherwise, you can manually transfer cash into there over the course of the year on your own schedule.

Do I do Roth or Traditional?

This is a tough question. I hope to post a cool spreadsheet I made exploring these options in a few days. Briefly, Roth means “pay taxes now, don’t pay taxes when you retire” and Traditional means “save on taxes now, pay taxes when you retire”. The choice between these two affects your tax efficiency–how much tax you pay over the course of your lifetime vs. the minimum you could have paid.

For now, I’d follow this rule of thumb: If you feel like you’re early in your career, and making less than you probably will in the future, I’d go with Roth. If you’re at your earnings peak, go with Traditional, unless you can’t do so because you’re over the income limit (in which case go back to Roth).

Anything else I should know?

There’s a cool advantage of a Roth IRA when it comes to buying a house. You can withdraw up to $10,000 in earnings and contributions penalty-free from your Roth IRA to put toward the down payment on your first house!

Do you have an IRA account? Are you saving for retirement yet? Any good ideas for how to manage your IRA, or thoughts on choosing between Roth vs Traditional?

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