The two basic types of retirement accounts are the 401(k) and the individual retirement account (IRA). While it is easy to confuse the two, they are actually quite different. While a 401(k) is an employee-sponsored account, anyone can open an IRA. This makes it an important product for people who do not have access to a 401(k) or who have already maxed out contributions to that account.
Unfortunately, the contribution limits for an IRA are significantly less than for a 401(k). However, they remain extremely important vehicles for retirement savings because of their tax advantages. An IRA is a way for the government to incentivize retirement savings outside of the employee-sponsored account.
The Various IRA Options Available Today
To open an IRA, individuals only need income from a job that is claimed for tax purposes, which rules out income from Social Security or an investment. When opening an IRA, individuals need to choose between a traditional and a Roth account. Like a 401(k), an IRA comes with certain tax benefits.
With a traditional account, individuals can contribute to the IRA and avoid paying any taxes on those contributions. However, when money is withdrawn from the account, it is taxed at that time. A Roth account involves investment of taxed income. Later, withdrawals can be made without paying any taxes, provided that individuals do not touch the account until they are at least 59.5 years old.
Some forms of specialty IRAs exist. For example, a simplified employee pension (SEP) IRA is geared for small-business owners and self-employed individuals. These accounts operate much like other IRAs except that they have much higher contribution limits.
Small-business owners are required to contribute the same rate to eligible employee accounts and their own. In other words, if the owner saves 10 percent of compensation, 10 percent of an employee’s compensation must also be saved. Employees cannot contribute directly to their own SEP IRA.
Another product is the Savings Incentive Match Plan for Employees (SIMPLE) IRA. This product is designed for companies with 100 or fewer employees. A SIMPLE IRA is easy to set up and allows employees to contribute to their own accounts.
Questions to Think about When Opening an IRA
Individuals can open IRAs through most financial service providers, from banks and credit unions to brokerage firms. Different service providers offer various advantages and disadvantages, so it is important to do some homework before opening an account.
Ideally, the financial institution provides individuals with a wide range of resources, from online education materials to in-person meetings, to help guide choices. These resources can help individuals plan for the future. Also, different providers will charge different types of fees. While some companies charge monthly fees, others have customers pay per trade.
Sometimes, companies will charge both monthly and trading fees, so it is important to understand the full payment scheme. Otherwise, individuals may end up paying a lot more for the service than they originally intend. It is also important to figure out what types of investments can be held in the account.
The point of opening an IRA is to invest money for retirement and have it grow over time. As a result, the exact investment options tend to matter quite a bit—especially for people who like to play an active role in investing decisions. People who prefer a more passive approach to investing should consider the possibility that they may want to get more actively involved in the future.
The Basics of Investing in an IRA
When it comes to investing money through an IRA, people need to consider the tradeoff between risk and return. An IRA should be viewed as a long-term investment. Generally, individuals will use an IRA to invest in stocks, especially if they are more than a decade away from retirement.
The stock market involves more risk, but it also usually yields higher returns than products like a certificate of deposit or a Treasury bond. While it is highly unlikely to lose money with these safe investments, individuals will also not earn much money. Different service providers may have some guidance to offer about how to navigate the creation of an effective portfolio. However, it is important that customers not feel pressured.
Alternately, individuals may want to take a fairly hands-off approach to investing in an IRA. In these cases, they may choose something like a total market index fund, which provides access to the kind of diversity needed to mitigate much of the risk involved in the stock market. These funds choose investments from a range of different geographic locations and across a number of different industries.
Individuals would struggle to obtain such diversification alone, even if investing very large sums of money. This option is for people who are willing to leave their money in accounts for long-term gains without the need to micromanage it. Another option for people who prefer a hands-off approach is a robo-advisor. This service will select investments based on the investor’s preferred cost and risk profile.