How to Start an IRA (or Roth IRA)

How to Start an IRA (or Roth IRA)

You always hear us finance bloggers telling you to invest for your retirement. We use big words like 401(k), 403(b), IRA, and Roth IRA, but usually assume you all know what they mean and how they work. Today, I am going to share the basics of what you need to know to open and fund an IRA or Roth IRA account.

What is an IRA?

An IRA is a self-directed Individual Retirement Account. The government allows for two types of IRA accounts, each with certain benefits for Americans planning to retire.

A traditional IRA is a tax advantaged account that allows you to save for retirement while either deferring taxes until you retire, likely at a lower tax rate due to a lower income in retirement. A traditional IRA has a similar tax treatment to an employer 401(k) or 403(b) account.

A Roth IRA is a newer retirement vehicle that you contribute to after taxes. When you retire, you can withdraw all capital gains tax free. There are also special rules for first time homebuyers to withdraw capital gains tax free. You can always withdraw contributions without a penalty.

When you use these types of accounts, you are agreeing that this money is, in fact, intended for retirement and will not be withdrawn before unless you meet requirements for early withdrawal. If you take the money out early, you have to pay very large tax penalties. Take care when deciding where to contribute first, a 401(k) or a Roth IRA.

How to Open an IRA

Opening an IRA is the easiest part. You just have to pick a bank or brokerage to hold your account. I highly suggest opening your account at a full-service brokerage with low trading fees and a strong portfolio of no-fee investments, research tools, and customer support.

I have my IRA accounts at Charles Schwab. I like to keep them in the same place as my banking and other investment accounts, so it was the best choice for me. For a brand new investor primarily focused on retirement, I suggest Vanguard due to their low-fee fund selection.

How to Fund an IRA

This is the easy part. Once you have your accounts, simply link them to a bank account. You can fund the accounts with an ACH bank transfer between your checking account and your investment account.

Make sure to stay under the annual contribution limit set by the IRS. You can contribute for the prior calendar year until tax day in April, so do your best to max out the account to get the best tax advantage.

Also note, you can’t contribute more than your taxable earnings for the year you are contributing.

Keep Good Tax Records

When you invest in a traditional IRA, your investments can be made with pre-tax dollars. However, if you are investing from your own income, you have likely already paid taxes on the money through your paycheck. If that is the case, you can deduct the amount you contribute from your taxable income, lowering your taxes by your top tax level, which is 25% for most of us.

At the end of the year, regardless of your account type, you should receive information from your investment firm about a 1099 form for your taxes. If needed, the firm will send you, either electronically or by snail mail, a 1099 form for your taxes.

Take Advantage of This Amazing Opportunity

We all can’t count on social security when we retire. We can, however, count on ourselves. If you invest diligently and intelligently, you will build up a big nest egg.

Invest regularly in long-term assets when you get started with retirement savings. As I like to say, invest early and invest often.

What Retirement Accounts Do You Have?

I am a big fan of keeping my accounts simplified, but I do need different retirement accounts for different purposes. How do you structure your accounts? How do you invest? Please share in the comments.

Originally written January 20, 2009. Updated February 6, 2013. Image by PT from PTMoney.com / Flickr

Comments

  1. Randall says

    It’s also worth mentioning that income limits apply to the Traditional IRA deduction. Details are on the IRS page here: http://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits

    For a single filer participating in an employer retirement plan (e.g. 401(k)), the limit is only $58,000. If your income exceeds this limit, is there ANY advantage to having a Traditional IRA? I think it makes sense if you are rolling over a 401(k) balance, to avoid paying taxes. Otherwise, seems like a Roth would be the logical choice, or a taxable investment account if you have more than $5500 to invest (the 2013 limit).

    • says

      That is a good point. The Roth IRA also has income limits for retirement investing. If you are over the limit, there is no benefit to using either of those accounts. In that case, you are better to just max out your 401(k) and put extra savings into a standard individual investment account.

      If you are rolling over a 401(k), definitely use a Rollover IRA to avoid the tax penalty. Keep things tax free as long as possible.