An IRA is a tax advantaged account similar to a 401k. The acronym stands for Individual Retirement Account. IRA accounts aren’t an investment in themselves. They are just a basket in which stocks, bonds, and mutual funds are held. By wrapping the investments in the account and following the rules for IRAs the account receives favorable tax treatment. An IRA can be setup as a traditional IRA in which contributions are made pretax. Or as a Roth IRA in which contributions are made after tax. While a 401k is organized through an employer anyone with income can open and contribute to an IRA opened through a financial institution.
Roth vs. Traditional
A Roth IRA is funded with after tax dollars. While a Traditional IRA is funded with pretax dollars. The difference is made up on the back end when taking distributions. The distributions from a Roth IRA are not subject to tax. This is good since we already paid taxes on the money when it was earned and stashed into the account. Distributions from a Traditional IRA are taxable. This is all well and good since the tax was deferred when the money was earned and contributed to the account. Now that it is being withdrawn it is time to pay the piper.
The debate rages on as to whether a Roth or Traditional account is preferable. The answer comes down to your specific situation. If you paying 25% in taxes on every dollar earned now and plan on being in the 15% bracket in retirement then it makes sense to use a Traditional IRA account. This defers the taxes owed until later when paying the lower rate. On the other hand if you are in the 15% bracket now it may make sense to use a Roth paying the taxes now and not owing on the distributions later.
Where to open an IRA
Just about any bank, mutual fund company, or brokerage firm offers IRA accounts. The major difference between most institutions is the fees they charge, the investment options they offer, and the customer service they provide. When I was shopping around for an account provider for my IRA I spent some time vetting a couple of financial institutions. I eventually landed on using Vanguard but this is how I got there.
Read the disclosures from a potential account provider institution closely. Some will try to slip in an annual fee to manage the account. The funds held withing the account are already charging management fees so there is no reason to tack on a second layer of fees. Also check the fees on the funds that are available to invest in within the account. There should be a low cost index fund option. If all of the available funds on the investment menu are actively managed high fee funds I’d nope on out of there.
Some banks only offer deposit accounts within their IRA funds. Which is why even though I’d like to support my local credit union by opening an IRA with them the lack of a brokerage window sends me packing. To keep my desired asset allocation I need to keep the funds within the IRA invested in broad market index funds. Only having deposit accounts available would have tipped my asset allocation too far towards cash and away from my target allocation.
The third thing I’d check on a potential account provider for an IRA is their customer service. Check some reviews on the company and maybe even call the customer support line. As a potential customer looking to hand over thousands of dollars to the financial institution for them to manage I want to work with an institution that I can contact. If the automated answering system takes more than a minute or two to get me to a real person I am highly skeptical of the company.
How to Fund an IRA
This one is straightforward. You must have earned income. So as long as you are earning a wage you can stash the income in an IRA up to the contribution limit for the year. If you earn less than the contribution limit you can only fund the account up to the amount you earned.
When it is time to make my annual IRA contribution I hop on the account providers’ website. From there I initiate a transfer of the funds from my bank account to the mutual fund company. A few days later the funds have cleared and are sitting in the settlement account. At that point I move the cash into my preferred investments within the IRA account. I make the contributions early in the year as a lump sum since time in the market is something I can control. Lump sum versus dollar cost averaging is its own blog post.
The annual contribution limit is an umbrella over all IRA accounts. So if you get fancy and have an IRA at two different financial institutions the contribution limit is across institutions. Over contributing comes with penalties so play by the rules. The limit also encompasses both traditional and roth accounts. The contributions for a year can be split across both accounts as long as the total contributed stays under the limit.
Required Minimum Distributions
The funds in a Roth account can be left in as long as you want. The tax man has already received his due and has no interest in what you do with the funds. On the other hand with a traditional account the taxes were deferred up front. RMDs are the mechanism through which the tax man gets his due. April 1 of the year following the calendar year in which you reach age 70 and a half you must start taking distributions from a traditional account. The financial institution handling the account will be able to determine what the RMD amount is. The IRS also publishes tables and worksheets that can be used to determine what future RMDs might look like based on life expectancy and the projected future value of the account. I don’t expect the rules to remain static for the next couple of decades to I use the information for general planning.
Since I don’t like the idea of having to take distributions on a predetermined schedule that doesn’t have any flexibility in it for my specific tax situation my plan is to roll over portions of the tradition to the Roth. Paying taxes at the time of the rollover on the portion rolled. That way I can roll as much or as little in a given tax year as matches the whole of my current situation. Once everything is rolled over to the Roth there isn’t a set schedule in which distributions must be taken and thus increased flexibility.