IRA stands for an individual retirement account. IRAs provide tax breaks like workplace 401(k)s but you can open them yourself. You can use one along with your workplace plan. Or you can open one if your employer doesn't offer an option to save for retirement.
But you need to know how to open an IRA in order to get started. This guide will help you figure out everything you need to know, including how to choose the IRA account that’s right for your financial goals.
Step 1: Choose between a traditional vs. Roth IRA
If you want to open an IRA, you'll first have to decide on what kind. There are two main types available for most people:
- A traditional IRA
- A Roth IRA
You can open both, but the contribution limit for them is combined. In other words, in 2020 and 2021, you're allowed to contribute a grand total of $6,000 or $7,000 if you're 50 or older. This can be split between the two accounts, or contributed to one or the other — but you can't put $6,000 into a traditional IRA and another $6,000 into a Roth IRA.
With a traditional IRA, if you meet the income qualifications, you get to take a tax deduction for your IRA contribution. So if you invest $6,000 in 2020, your taxable income would be reduced by $6,000 for this year. You don’t avoid taxes altogether though; a traditional IRA is what’s known as a tax-deferred account. That means you pay taxes when money is taken out in retirement. In addition, you must begin taking mandatory withdrawals (called required minimum distributions) once you reach age 72.
Traditional IRAs have an income limit for tax-deductible contributions if you have a workplace retirement plan or if your spouse does, but no income limit for non-deductible contributions.
- If you're single or file as head of household and have a workplace plan, deductible contributions begin phasing out at an income of $66,000 in 2021 and no deductible contributions can be made once your income is $76,000.
- If you're married filing jointly and you have a workplace plan, the deductibility of your contributions starts phasing out once your income is $105,000 and you can't make any more deductible contributions once it hits $125,000 in 2021.
- If you're married filing jointly and you don't have a workplace plan but your spouse does, the phase-out starts at $198,000 and you can't deduct any contributions with an income of $208,000 or higher in 2021.
- For married separate filers, the phase-out starts at $0 and no contributions can be made once your income hits $10,000.
With a Roth IRA, there's no tax deduction available in the year contributions are made, but you won't pay taxes on money you take out as a retiree and your earnings will also grow tax-free. There are no RMDs with a Roth IRA. And although you'll face an early withdrawal penalty for taking out gains before age 59 1/2, you can withdraw your contributions at any time without penalty. That's not the case with a traditional IRA, where virtually all early withdrawals are subject to a 10% penalty.
Roth IRA accounts also have an income limit, but if you exceed it there's no option to contribute at all. Here are the limits for 2021:
- Eligibility starts to phase out for married joint filers with an income of $198,000 and no more contributions can be made once it hits $208,000.
- If you're married filing separately, the phase-out begins at $0, and no contributions are allowed with an income of $10,000.
- Single filers will see eligibility to contribute start phasing out at $125,000 and no contributions can be made with an income of $140,000 or more.
To decide which type of account is best, think about the potential tax benefits. Would you prefer to reduce your tax bill now or later in retirement? This could depend on whether you think you'll owe more in taxes now or later in life. You might also think about whether you want to take withdrawals on a schedule set by the IRS (as you would with a traditional IRA) or have the freedom and flexibility to leave your money invested as long as you want (as you could do with a Roth IRA).
Step 2: Choose where to open an account
You have many options for opening an IRA. For most people, it might make sense to invest at least some of your retirement money into stocks, which means you'll want to pick a brokerage firm that allows that.
If you don't want to select investments yourself, many popular robo-advisors allow you to open an IRA. The benefit of this approach is that you just answer a few questions about your age, retirement goals, and risk tolerance, and your money is invested in a mix of assets based on your answers and retirement timeline. The downside is that you typically have to pay a small fee for robo-advising services.
If you don't want to pay for a robo-advisor or you'd prefer to take a more hands-on approach and manage your money yourself, there's a wide variety of discount brokers that offer lots of investment options, commission-free trades, and more.
Many banks and credit unions also offer IRAs, including those that allow you to invest in CDs or savings accounts. The features on these IRAs can vary substantially from one financial institution to another and you may be limiting the potential returns you can earn by choosing this option. You also reduce your risk, though, as investing in equities always comes with a chance of losing money.
Step 3: Open your account
Once you've researched options for brokerage firms or banks and found one that looks good, you can open your account. The specific requirements will vary but you'll generally need to provide your full name, your Social Security number, your contact details, and your financial information to fund your account. You may need to provide your driver's license as well, and perhaps answer some questions in order to verify your identity.
Step 4: Fund your account
Once your account is open, the next step is to put some money into it. And you have a few different options to do that.
If you have an old 401(k) at a past place of work, you could do a 401(k) to IRA rollover. This involves completing some paperwork with your current 401(k) administration. You may have the option of a direct rollover, where the money is sent right from the 401(k) to your new IRA. Or you may receive a check, which you'll have to deposit in your new IRA within 60 days. If you miss the deadline, taking the money out of your 401(k) could be treated as a withdrawal, which would mean you may be subject to any early withdrawal penalties that apply.
If you roll over money from a 401(k), you’ll most likely want the account types to match. In other words, if you have a traditional 401(k), you'd want to roll over the money to a traditional IRA versus a Roth IRA. Because Roth accounts are funded with after-tax dollars, if you don’t match account types, you could end up owing taxes on the funds you roll over, which could be very expensive.
In some cases, it might make sense to switch to a Roth (this process is called a "Roth conversion") but you'd need to make sure you understand all the consequences of this. Talking to a financial or tax advisor before you do this could be helpful.
You also have the option to simply deposit money by either having it withdrawn directly from your bank or savings account or by sending in a check. In most cases, you can just provide your routing number and account number and the money will be moved over within a few days at no cost.
When you make your contribution, you may have to select which tax year it is for. That's because you have until tax day to make contributions for each calendar year. For example, if you wanted to contribute for 2020, you'd have until April 15, 2021, to do so. If you put money into your IRA in January, February, March, or early April 2021, you'd get to choose whether to make the contribution for 2020 or for 2021.
When you contribute, be sure not to exceed the annual contribution limits. Again, this could be up to $6,000 for both 2020 and for 2021. And those who are 50 or over get to contribute an additional $1,000 in catch-up contributions for a grand total of $7,000.
If you want to maximize the chances of hitting your limit, consider setting up automated deposits. Most brokers and many robo-advisors allow you to do that so money is withdrawn on a set schedule. Choosing to have funds taken from your paycheck every payday would allow you to invest money for your future before you get a chance to spend it.
Step 5: Choose your investments
If you opted for a robo-advisor, you won't have to make any investment choices — an algorithm will do it for you. But if you picked a different type of IRA, then you have to select what assets to buy with your IRA money.
The options available to you depend on where you opened your IRA. If you picked a bank, you typically won't have much choice. Your money will probably go into a money market or CD account. If you picked a broker, you can usually invest in most anything they offer including stocks, exchange-traded funds, and mutual funds. Stock shares in individual companies could be riskier than investing in ETFs or mutual funds, which often track financial indexes or specific industries and which provide more diversification.
There are some IRAs that also allow you to make alternative investments. For example, you may be able to invest in gold or cryptocurrency or may be able to open an IRA with a peer-to-peer lender. Unless you're confident you have a solid investing strategy, however, you may not want to gamble your retirement money on what are considered to be more speculative investments.
How much does it cost to open an IRA?
Most brokerages don't charge to open an IRA. However, if you choose to open an IRA with a robo-advisor, you could owe management fees. There may also be some costs associated with the particular investments you select.
Where is the best place to open an IRA?
The best place to open an IRA depends on your needs. If you want to manage your own investments, a brokerage account that offers you a wide variety of choices such as stocks, bonds, mutual funds, and ETFs could be a good option. If you want to reduce your risk, you might prefer to open an IRA that allows you to put your money into a CD or money market account. And if you want your funds managed for you, a robo-advisor might be a better bet.
Can you lose money in an IRA?
You generally cannot lose money simply by depositing your funds into an IRA as most banks are FDIC-insured and good brokerage firms are insured by the SIPC. However, once you make the choice to start investing the money in your IRA, there is always an inherent risk. If you buy stocks or ETFs and they perform poorly, for example, you could lose money.
Opening an IRA is a good way to benefit from tax advantages on your retirement savings. But you need to make the right choice about which kind of IRA to open, where to open your account, and what to invest in within your IRA. If you aren't certain how best to approach these issues, working with a financial advisor may be a good idea.