How to Start Investing with an IRA
In a previous article, I wrote about Saving & Investing for Retirement. In that article, I wrote that the three investing accounts you need were a 401(k) plan, an IRA and a taxable account. Like the three legs of a stool.
Your 401(k) is handled at your place of employment. Human Resources gives you all the forms and all you have to do is fill them out properly. All I have to say about 401(k) is be sure to contribute the maximum you can to get the company match.
But you have to handle the IRA on your own. You must to take the initiative yourself to open and fund an IRA. Today we’ll talk about IRAs.
What is an IRA?
IRA stands for Individual Retirement Account. The U.S. tax code allows individuals to put away money for their retirement that is tax deferred. Tax deferred means you don’t pay taxes on the money now when you contribute to your account. You pay taxes later when you make withdrawals. The advantage is that your money compounds faster.
The rules for contributing to an IRA are complex, so I am leaving the details to more knowledgeable writers. The best source would be the IRS Publication 590 Individual Retirement Arrangements (IRAs) which you can find on the Internal Revenue Service website. Download the Publication 590 PDF file and study it. But generally, for 2009 you are allowed to up to $5000 of your earned income into an IRA. Also be aware that you have up until April 15, 2010 to make your 2009 contribution. Check all the rules that apply specifically to you.
IRAs are for retirement in your old age, so the IRS imposes penalties if you withdraw money before you are age 59-1/2. Generally speaking, don’t plan on using IRA money before you are 60 or 65. Don’t plan on taking out for a new car, a house down payment or college tuition. Use separate savings accounts for those things. Your IRA is for retirement only.
Two Kinds of IRAs
There are actually two different kinds of IRA accounts: Traditional IRA and the Roth IRA. With the Traditional IRA, you don’t pay income taxes on your contribution or any gains inside the account. Instead, you will pay taxes when you make withdrawals many decades later. Your IRA grows faster without having to pay taxes on interest, dividends and capital gains.
The other kind of IRA is the Roth IRA. With this kind of IRA, contributions come from before-tax money. But after that, no taxes are paid ever. Your account can grow and you never pay any taxes on the interest, dividends or capital gains.
My suggestion is to us the Roth IRA rather than the Traditional IRA. It is much better to know that all the money in your Roth belongs to you alone. With the Traditional IRA, the IRS has a claim on some of your money which they will collect in taxes when you start making withdrawals. The are some other benefits which favor the Roth IRA like you have to start withdrawing from Traditional IRAs at age 70. But I will make it real simple for you: Forget the Traditional IRA and open a Roth IRA.
Where to Open An IRA?
An IRA requires a custodian which is the financial institution where you have your IRA. There are many choices for custodians including commercial banks, brokerage houses, mutual funds, credit unions, etc. To make it simple for you, I am going to narrow it down to three choices: Fidelity Investments, Charles Schwab or Vanguard.
Fidelity Investments is a huge mutual fund family. To open an account, just go to Fidelity’s home page and click on OPEN AN ACCOUNT. Then follow the instructions.
Charles Schwab was the original discount broker. But they also have mutual funds and everything else similar to Fidelity. Again, just go to their home page, click OPEN AN ACCOUNT and follow the instructions.
Vanguard is the biggest mutual funds house. They are known for low-cost mutual funds. These are mutual funds that have a low expense ratio. Vanguard is different from just about every other company because Vanguard is owned by its investors. Fidelity, Schwab and everyone else must earn a profit for its shareholders. Once again, just go to Vanguard’s home page and click OPEN AN ACCOUNT. All these companies want your business, so they don’t make it hard to start investing with them.
There is not a huge difference between Fidelity, Schwab and Vanguard. You can’t go wrong with any of them. One reason to choose one over the others is if you want to use a specific product that one has. For example, if you decide you want to use specific Vanguard mutual funds it might make sense to have your account with Vanguard. You may have to pay a commission to use a fund from another fund family.
Sometimes there are differences in things like customer service, the way the website operates, or the kinds of annual reports and the way to get tax forms. For example, some people have complained about the way Vanguard’s website works.
Do Your Homework
I recommend doing homework by spending time researching the choices for your IRA. If you have other recommendations for custodians, research them as well. Visit their website and read the sales literature to see what each is offering. Remember that it is sales literature so take everything with a grain a salt.
You can also see how satisfied their customers are by using one of the online message boards like Morningstar. Morningstar provides investment research for stocks, bonds and mutual funds. But they also have online discussion forums devoted to fund families like Fidelity Family, Vanguard Funds and T. Rowe Price Funds. Visit Morningstar’s Discussion Forums and read the postings for a while.
If you have questions, ask the community, but must register first. At this time, Morningstar offers a free membership. Morningstar is one of the best resource sites for individual investors, so I highly recommend getting a membership with Morningstar and visiting the discussion forum for your fund family. You will learn a lot.
Choose your IRA custodian carefully because it is a pain to switch from one to the another. I also recommend just having one IRA to keep it simple. Even when you become mega rich with $10 million, you still only need one IRA.
Now just to simplify things for you, I am going to suggest opening your Roth IRA account at Vanguard. Most of the stuff I will write about in later articles will be slanted towards Vanguard mutual funds.
How to Fund Your IRA
Most of these places have a minimum initial deposit which typically might be $3000. So when you open your account, you should have $3000 or more in your checking account. Suppose you saved up $5000 in a savings account that you are going to use for your Roth IRA contribution for 2009. You would transfer $5000 from you savings into your checking account. Then you could write a check for $5000 and mail it to Vanguard.
However it is probably easier to do an electronic funds transfer from your checking account to Vanguard money market mutual fund. You just type in your bank’s routing number and your checking account number. Vanguard will automatically transfer the funds from you checking. Fidelity and Schwab work the same way.
What to Invest In
What to invest in is a complex subject. The best thing to do is have your deposit go into a money market mutual fund. To the investor, MMMFs act as cash accounts that pay interest. An examples of a mmmf is Vanguard’s Prime Money Market Fund (Ticker Symbol: VMMXX). This fund is a pretty safe place to park your money while you decide what to invest in. Although losses are possible, no one has ever lost a penny in this particular fund.
With a money market fund, the manager’s goal is to keep the share price at $1 so you can get out what you put in. (Be aware that money market funds are not guaranteed like FDIC-insured bank savings accounts. Some more aggressive money market funds have lost money. There is always an element of risk in investing, which means the possibility of losing money.)
Take Action
If you are eligible, open up a Roth IRA at Vanguard and make your 2009 IRA contribution before April 15, 2010. If you decide to do this, here are the steps you would take:
- Get at least $3000 or up to $5000 extra money into your checking account
- Open up a Roth IRA with Vanguard
- Park your money in the Vanguard Prime Money Market Fund
The views expressed in this article are those of the author and do not necessarily represent the views of Laguna Beach Bikini, its editors, staff or any other organization.