Individual Retirement Account

Today I opened my first IRA.  It took about 15 minutes on Vanguard’s website.  If you haven’t started saving for retirement then an IRA is a great place to start (a company matched 401k is even better).

Traditional vs ROTH

One of the first questions you will encounter when opening an IRA is whether you want to open a Traditional or a ROTH account.

An IRA comes in two flavors, just like 401ks.  You can open up a traditional IRA, a ROTH IRA, or both.  The difference between the two is where the money comes from.  In traditional IRAs, the kind I just opened with Vanguard, investment money comes from pre-tax dollars.  So if I make a $1 profit from my business, that entire $1 can be invested immediately.  With a ROTH IRA, if I make a $1 profit, I pay tax on that profit and what is left over (¢85 to ¢92) gets invested.  Of course the flip side to this is that when it comes time for me to withdraw the invested money, I pay taxes on gains for a traditional whereas I would pay no taxes on a ROTH.

In short, pick a Traditional IRA or 401k if you expect to be in a lower tax bracket when you retire than you are when you are working (most everyone fits into this boat).

IRA vs 401k

If you have access to an employer sponsored 401k plan, it would probably be best to max that out ($18000/year) before opening up an IRA.  Most employers contribute some amount of money to your 401k as long as you do as well.  In essence, you get free money from your company.

IRAs are available to everyone that works and have an income.  They are also really easy to set up and give you total control over the fund choices.  However, the contribution limits are lower, only $5500 per year.

Why Not Both?

If your employer offers a 401k plan, or you are self employed and take the initiative to create your own, then you can contribute to both a 401k and an IRA.  The advantage of ‘maxing’ out both accounts is that it shields up to $18000 (401k) + $5500 (IRA) = $23500 from taxes.  Add a spouse doing the same thing and suddenly your taxable household income drops by a whopping $47,000.  Wowza, that’s about seven thousand dollars of taxes saved!

What Fund To Invest In?

Call me lazy, but I am a big fan of Vanguard’s Target Date Retirement funds.  These all in one index funds include equities and bonds in a slowly changing ratio to make the portfolio less volatile as you reach your target retirement date.  The one I am using, VFFVX (2055 target date) has a modest expense ratio of 0.18%.  I could do a bit better than that by manually managing my own three fund portfolio, but the difference that the lower expense ratio makes in extending working years can be measured in weeks.


Leave a question in the comments if you’d like to learn more about retirement savings.

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