IRA Basics: How to Use an IRA and Start Investing Soon

Posted on
April 9, 2020
Young Money

IRAs are the US government's incentive for you to start saving for retirement. There are so many articles about IRAs, but beginners can find all the logistics overwhelming! I've spent too many hours researching and debating with fellow money-nerds at the risk of over-optimizing. Now, I choose to focus on the IRA basics to starting.

Investing early is better than being indecisive. For most of you learning about investing, it's more valuable to build a healthy relationship with money - saving & investing while building your career and personal relationships - than becoming an expert on tax strategies.

IRA Basics: Key Takeaways

Investing in IRAs are a great savings vehicle for tax-free investment gains. This article is designed to get you started investing as soon as possible with the core basics you'll need. Once you figure out (1) how to open an account and (2) which portfolio of investments work for you, you're an investor!

When Should You Invest in an IRA?

You should only invest in IRAs when you have enough money to cushion you through daily life. IRAs are great long-term investment vehicles with tax benefits. But they also have penalties and hurdles to withdraw before age 59 ½. It's only worth contributing to an IRA when you don't need that money and can now save for your future self. (For a rainy-day fund, most people will benefit from saving a few months of expenses in a High Yield savings account.)

Why Invest with an IRA?

IRAs have tax benefits from the US government to encourage Americans to save for retirement each year. The most important benefit for young people is tax-free investment gains. This means that you do not have to pay taxes on your investments (normally 'capital gains' are taxed up to 20%). This benefit compounds as your investments grow year after year. If you contributed $6,000 each year starting from age 24, you would likely reach $1 million by age 60! This assumes annual returns of ~7%, slightly below the S&P 500 historical average.

If you can save $6,000 per year to contribute to your IRA and invest in a Growth portfolio, you would historically be a millionaire.

How Do You Pick an IRA?

Two common questions pop up for people who want to open an IRA. (1) Do I use Traditional or Roth IRA? and (2) Where do I open an IRA?

While there are many tax optimization theories out there, the biggest priority is to figure out whether you quality first. Nerdwallet has the full details on eligibility and I'll include their eligibility tables below.

Basics of IRA Eligibility

Traditional IRA:  Anyone with income is eligible. However, if your employer has a retirement plan (401k, pension, etc.), your taxable income will limit how much you can deduct from taxes. We established earlier that the most important benefit of IRAs was tax-free gains, which still apply regardless of your income! Basically people with any level of income should aim to invest using an IRA.

Roth IRA: You can contribute fully to your Roth IRA at taxable income levels below $124k. After that, you are limited or altogether not allowed to use the Roth IRA program.  However, you can still use the Backdoor Roth IRA method.

Backdoor Roth IRA: For high income earnings who are limited in Roth contributions ($124k+ in 2020). Contribute fully to your Traditional IRA (you will not quality for tax deductions) and roll over your Traditional IRA amount into a Roth IRA. Note, if you have earnings, those will be taxed on the rollover so try to move immediately or make sure your broker is only moving contributions over. If you try this method, make sure to read the fine print in this Investopedia article to ensure you do not trigger taxes!

Traditional vs. Roth IRA vs. 401(k)

Decisions, decisions! Choosing an IRA is a hurdle that keeps many people from opening an account. Instead of reading through all the details of every option, use this decision tree to guide you first.

I tend to believe Roth or Backdoor Roths are better than Traditional IRAs for most people, but this is ultimately a personal call. Deciding between Traditional and Roth IRAs requires knowing what your life situation will be at age 60 - an educated guess at best! So I encourage you to focus on using whichever one you are eligible for and spending more time and energy on increasing salary, savings money or maxing out 401(k) / pensions. However, below are a few main differences I personally find important.

  1. Roth IRAs are generally more flexible with (1) withdrawal without penalty after 5 years and (2) no required withdrawals at age 72. You should try not to remove your money, but you can take out your contributions without penalties or additional taxes in cases of financial emergencies.
  2. Check your company 401(k) or pension retirement program first! Before you throw all your hard-earned savings into an IRA, check for a 401(k) contribution match from your employer. This is free money the company gives you through your 401(k), so you want to at least match that amount. Then, you can compare between 401(k) and IRA options. Comparing matters when you're still growing your salary, but the best possible option is to maximize all your tax vehicles (IRAs, 401(k)s.

How to Open an IRA Account?

Opening an IRA is quick and easy, but you'll need to decide on a broker or robo-advisor. Robo-advisors are great for absolute beginners but charge a a management fee (usually 0.25-0.40%) which adds up over time! If you are committed to learning more about financial independence or checking your account at least once a year, I recommend using a broker.

Choose between some of the top brokers (Vanguard and Fidelity are very beginner-friendly) and pick a few lowest fee Index Funds or ETFs that mirror the stock & bond markets for a diversified, long-term investment.

This chart provides historical (long-term) returns by portfolio, which do not fully predict future returns! Source: Fidelity, Ibbotson Associates (1926-2018)

Choosing a portfolio is easier than it looks! Rather than "having a view" on where the markets will go, beginners will do well to focus on a "risk-weighted" portfolio.

  1. Decide how aggressive you want your portfolio to be. As a general principle, the greater returns usually come with greater risk (downside) too.
  2. Pick a few index funds / ETFs with the lowest fee that mirror those returns.

Popular indices that all companies (Vanguard, Fidelity, Charles Schwab) offer:

  • Stocks: Total US Market, Total Global Market
  • Corporate Bonds: US High Yield, US Investment Grade
  • Government Bonds Short Term and Long Term US Treasuries, Municipal Bonds
  • Real Estate: US Real Estate
Common Index Funds by Name at Fidelity and Vanguard

Additional Resources

Know the basics, and then build up from there with these resources below. Finance is often a game of optimization - learning the details of different accounts helps you make better decisions. I encourage you to read and learn more about investing, but not let 'unfamiliarity' block you from getting started.

Nerdwallet: How and Where to Open an IRA

Investopedia: How to Set Up a Backdoor Roth IRA                            

Nerdwallet: Index Funds - How to Invest and Best Funds to Choose  (includes lowest fee index funds across brokers)

Disclaimer: I am not a personal financial advisor. (More about me). These are solely best practices that I personally implement and want to share. Please invest at your own risk!


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