Investment 101: What is an IRA and How Does It Work

by Nicole
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Thanks for visiting my series on investments. This is part 3 of these series. If there is a topic you would like to be covered, please let me know.

To read part 1, “Investment 101: How the 401K Can Increase Your Wealth”, click here.

To read part 2, “Investment 101: How Compound Interest Can Make You a Millionaire”, click here

Similarities and differences between IRA and 401k

An IRA stands for individual retirement account. It is an investment account which serves as an excellent resource we have available to us to prepare for our future in addition to the 401k. Unlike 401k’s, IRAs are not offered through an employer and therefore, need to be opened on your own. This action is much easier to do than you’d think and if you keep reading I’ll show you how!

Much like the 401k, this is a retirement account that typically is not accessible until 59.5 years old. This money is not locked up and can be accessed in the event of an emergency, however, we would suggest not touching it until retirement as that is its purpose. Speaking of emergencies, if you haven’t read my article regarding how to start an emergency fund, you can be read it here

Roth vs. traditional IRA

There are 2 types of IRAs that exist, Roth and traditional. The biggest difference between a Roth and a traditional IRA is how and when you get a tax break.

The tax advantage of a traditional IRA is that your contributions are tax-deductible in the year they are made. The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed. 

Let’s simplify this even further…

Always start with the 401K

No matter what your income is or if your 401k makes you pay fees, you should always invest into your 401K FIRST if your employer offers a match. Be sure to contribute the amount needed to obtain the match because as we mentioned in 401K investment 101, the match is free money. 

After that, it’s your choice whether you want to contribute more to the 401K. For most people this is the best option because you won’t be seeing that money; it automatically gets taken out of your paycheck. Contributing money to your 401K is a method of “paying yourself first.” The money comes straight out of your paycheck and goes into this retirement fund. You don’t see it therefore you can’t spend it. Conversely, for the reasons listed below, it may make sense for some individuals to contribute to an IRA prior to or in conjunction with your 401K. This is a case by case basis and you should follow the steps below. 

4 reasons to open an IRA

1. You don’t have a 401K retirement plan at work (or you’re self employed) 

2. You already contributed the max to your 401K ($19,500) and want to contribute more

3. Your 401K plan only offers a traditional 401K and you would prefer a Roth IRA

  • If you are in a low tax bracket it makes a lot of sense to first contribute to your 401k up to the match amount then contribute any extra money you have to a Roth IRA.
  • Because you are in a low tax bracket, contributing to a Roth where contributions are made post-tax and withdrawals are made tax-free makes sense over getting a small tax deduction on traditional 401k contributions today.

4. You have a retirement plan at work but it has high fees and/or expense ratios

  • This is dependent on what plan your 401k provider your workplace has chosen.
  • Because your 401k plan only offers high fee investment options (in this case) it makes sense to contribute first to your 401k to get the match then to your IRA where you can invest for almost nothing. 

How to choose Roth or Traditional

  • The income contribution limits established make it easy to determine which account to invest in. Fidelity has a chart on their website which outlines it even further. 
  • If your adjusted gross income (link here to understand your AGI) is greater than $65,000 then you start to lose tax benefits.

  • If your income is greater than $75,000, you will not be eligible for the traditional IRA tax benefit aka you have to invest in the Roth. 

  • Anyone with an adjusted gross income (AGI) of $124,000 or less can contribute to a Roth IRA.

  • I personally think the Roth IRA makes more sense for most people. I have chosen to contribute to a Roth IRA because my 401k plan at work is the traditional type. I believe it is important to have diversification within your investments which is why I also opened a Roth IRA. More about my specific account below…

  • Fear not if your AGI is more than $124,000; there is still a retirement option for you. For all you high rollers out there who are looking to put all that extra money into a retirement fund, there is something called a Roth backdoor IRA. These finance people come up with some crazy terms, I know! I won’t go into detail about this on my blog since this is investment 101 and this topic is a bit more complex, but I’ll link to a helpful article. Click here to get information about the Roth backdoor IRA.

How to open an IRA and what to invest in

We would recommend using either Vanguard, Fidelity, or Schwab. It is very easy to do and once you open an account you can begin to fund it. See my instructions below on how I fund my own account!

The IRA contribution limit is $6,000 in 2020. Of course you don’t need to contribute all this money at once.

When you open an IRA, it is up to you to make the investment decisions. I realize this may seem overwhelming as there are quite a few options. I made some suggestions on where to invest in my prior post which I will link here. If you did not read part 1, investing in the 401KI would highly suggest doing so as the topics are similar.

For a young individual, who has a high risk tolerance and understands this money is going to be in this account for the long term, I would suggest an equity ETF.

Personally, I own the ETF called VTI which is the Vanguard total stock market ETF. This represents the US stock market. When you go to purchase a security (if using Vanguard like I do) the screen will look like this:

a-healthy-profit-vanguard
  1. You’ll see the top picture on the left side of your screen. These are your options to choose the security. The security I chose was VTI as I mentioned above. 
  2. You’ll want to write in how many shares of that security you want to buy. On the right side of your screen you’ll see the bottom picture. This tells you the price per share. So if you bought 1 share, you’d pay $153.71. This number is constantly changing when the market is open. Don’t worry so much about the cost per share or try to “time the market”. When you’re ready to invest JUST DO IT! You should only execute orders when the market is open (9:30am-4pm EST). 
  3. For the simplest execution you would choose “market” for the order type
  4. For the simplest execution you would choose “day” for duration 

Can an IRA make me wealthy?

DUH!!!! If you allow the money to sit in the account, untouched, for the long term, yes. Remember that the market has historically increased 8%. 

If you didn’t read last weeks post on compound interest you should totally do so as it pertains to the example below. I’ll link that article here

Assuming you’re a 25 year old who has aspirations to contribute the maximum $6,000 to the Roth IRA, using the principles of compound interest explained last week, you would easily have over 1 millionaire dollars by age 60 in just your Roth IRA alone. Note: the contribution limit does increase regularly so you may even be able to contribute more!

a-healthy-profit-money

Please comment below and let me know if you opened an IRA. If there are still questions or concerns, please know I’d be happy to help.

XO,

Nicole

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