Investment Tip of the Month
from Morningstar Investment Research Center
Question: I am already contributing to my 401(k), but I’ve heard I should have an IRA too. How do I open one up? Where do I start?
Answer: You’ve heard right–an IRA can make a great companion to your 401(k) savings. While both vehicles allow your money to compound on a tax-deferred basis (or tax-free, if you choose the Roth option), IRAs offer some advantages that most company retirement plans do not. For starters, you can put almost anything inside of an IRA wrapper. And while 401(k)s often carry an extra layer of fees, you don’t need to pay any extra costs to invest in an IRA. Another piece of good news: While not everyone can contribute to a company retirement plan, almost anyone is eligible to participate in some type of IRA as long as they’re making taxable income.
By following these three steps, you’ll be well on your way to setting up an IRA.
Step 1: Decide between a Roth and traditional IRA.
There are two main types of IRAs–traditional and Roth. The key difference is tax treatment. With a traditional IRA, you may be able to deduct your contribution on your income tax, as long as your income falls below a certain level. Your money will compound on a tax-free basis, meaning you won’t owe income or capital gains tax on your IRA from year to year. However, when you take money out of a traditional IRA, you pay taxes on the distributions at ordinary income tax rates.
By contrast, you’ll put after tax dollars into a Roth–that is, Roth contributions are never deductible on your tax return. However, you won’t owe any taxes on your Roth account again, provided you follow the rules about when and how you can take distributions.
A Roth also offers additional flexibility that isn’t there with a traditional IRA. Even though the purpose of a Roth is to save up for retirement (and it’s really best to leave your money in there for as long as possible), you can withdraw your contributions from your Roth at any point–tax-free. Nor are Roth IRA investors required to take distributions at age 70 and a half (unlike traditional IRA investors), so if you don’t need the money for retirement, you can let the money compound and grow for your children or grandchildren.
Before you decide on which type of IRA will best help you meet your retirement goals, it’s important to consider how much you make now and whether you’re likely to be in a higher tax bracket come retirement.
Step 2: Decide what to put into it.
IRAs are essentially an investment wrapper in which you can hold an endless array of investment options. Because of the vast universe of investments to choose from, picking investments for an IRA can be a daunting task. For the beginning investor, broadly diversified mutual funds or exchange-traded funds are a good place to start because you can diversify risk across a large number of investments. Alternatively, you can use Morningstar Investment Research Center‘s Portfolio X-Ray to assess whether your current 401(k) portfolio has any gaps you need to fill with your IRA investments.
Morningstar Investment Research Center offers several research tools that can help investors put together a portfolio that is well-diversified but also simple and manageable. Investors can use the Fund Screener to input specific criteria that will help home in on funds that best suit their investment needs and goals. If you don’t know where to begin, clicking on the “Morningstar Screens” button allows you to choose from a menu of custom-built screens and quickly narrow in on some viable investment options. Another way to home in on some solid funds is to browse through our Fund Analyst Picks and ETF Analyst Picks in each mutual fund category.
Step 3: Execute your purchase.
Once you’ve determined what you’ll put in your IRA, you can go ahead and set up an account. If you’ve chosen a mutual fund, you may choose to deal directly with that fund company. This is a reasonable option if you plan to purchase funds from the same fund company, but you might be charged an additional fee to invest in funds outside of that specific fund company.
Alternatively, you can open up an IRA account through an online discount broker. Most offer both Roth and traditional IRAs with low trading commission rates, and you’ll be able to invest in an even broader assortment of investments, including mutual funds, exchange-traded funds, and individual stocks. (Just be careful that you’re not racking up a lot of transaction costs with frequent buying and selling.)
Once you’ve chosen a discount broker, you will have to complete an online application or you may need to print out a hard copy of the form and mail it in with a check. More often than not, online brokers and mutual fund firms will allow you to complete the entire application online, and you can then electronically transfer money from your checking or savings account to your new IRA account.
The contribution limit for IRAs is $5,000 for those under age 50 and $6,000 for those over 50. (If your income is over the limits, your allowable contribution may be reduced.) But rather than putting your money into an IRA all at once, you might consider investing the same amount at regular intervals throughout the year–a 55-year-old, for example, could invest $500 every month until he or she hit the $6,000 max for the year. Most fund companies and brokerage firms will allow you to sweep your contribution directly from your checking account into your IRA at a specified time each month. Finally, pay attention to whom you name as a beneficiary of your IRA.
A version of this article appeared on Morningstar.com on March 15, 2011.