When I’m forced to think about long-term financial planning and the big question mark that is the future, my face gets hot and I start hearing a faint buzzing sound in my ears. So I understand completely if the question “Should you get an IRA?” makes you cringe a little inside. Your 20s can be a difficult time to start thinking seriously about retirement — after all, it’s hard to feel overly concerned about what your bank account will look like when you're 60 when you’ve just gotten your first real job after a string of unpaid internships and finally being able to buy non-generic toilet paper feels like a luxury. But, painful though it may be, it’s vital to start thinking about retirement early because money that you invest now, which will have decades to earn compounding interest, could become a huge benefit in your future, when you may need to support yourself on retirement savings for 20 years or more.
Getting an IRA can be a great way to start saving for the days ahead, whether or not you already have a 401(k). Figuring out the different types of IRAs, how they work, and how they’re regulated may seem complicated at first, but it’s fairly simple once you know the basics. Let’s break it down:
What is an IRA?
“IRA” is short for “Individual Retirement Account.” It is a type of investment account that offers major tax breaks for retirement savings. You don’t have to rely on an employer to get one, and the IRS sets limits for how much you can contribute to the account at any given time. You set up an IRA through a custodian — a financial institution such as a bank, credit union, brokerage firm, insurance company, or mutual fund company. Depending on the type of custodian you choose, an IRA can hold a variety of asset types, including bonds, stocks, CDs (certificates of deposit), and real estate.
Why would I want an IRA?
There are a lot of reasons that an IRA could be right for you:
- You can maximize even relatively small savings through compounding interest. A few thousand dollars a year in your twenties invested in an IRA could result in a hefty nest egg forty years down the line.
- IRAs aren’t dependent on your employer or on sticking to the same job for a long period of time. That means that, even if you’re a freelancer, a part-time worker, or a contract-worker, you can still contribute to your retirement. Furthermore, if you think you’ll be switching fairly quickly between jobs for the next few years, you can take your IRA along with you, without having to worry about losing your employer’s match, as you would with a 401(k).
- IRAs offer significant tax breaks — you either defer paying taxes on your investment until you retire, or you pay taxes now and don’t have to pay anything in the future. Thus, they are a great opportunity to grow your savings.
How is an IRA different from a 401(k)?
You can only open a 401(k) through an employer, while you can get a traditional or Roth IRA on your own (More on the different types of IRAs below). With a 401(k), you decide what percentage of your paycheck you would like to go into your retirement account, and the money will automatically be taken out at every paycheck. Some employers offer matching in their contribution plans, which means that for every dollar you put in your account, they will contribute a certain percentage. This is essentially free money, which is great, but you usually have to stay in the job for a number of years in order to get all of it. If you switch jobs before your employer’s contribution is fully “vested,” then you will take all of your own contribution with you, but you may only get a portion of your employer’s. In contrast, an IRA is entirely funded by your money, and therefore isn’t dependent on staying in a job for a set amount of time.
Another major difference is that, with a 401(k), your employer offers a limited number of investment options from which you can choose. With an IRA, you have the power to choose your custodian (and there are a lot of them), as well as the types of investments you want to make.
What types of IRAs are there?
There are a numbers of types of IRAs, but the two main ones for individual investors are traditional IRAs and Roth IRAs. With both types, your money isn’t taxed while it’s in the account, but the primary difference between the two lies in how you pay taxes on the money going in and coming out. If you have a traditional IRA, you won’t have to pay taxes on the money that you put into the account, but you will have to pay taxes when you withdraw it later. With a Roth IRA, it’s the opposite case: You’ll pay taxes on the money when you put it into the account, but you won’t have to pay taxes on it when you pull it out.
Roth IRAs impose certain limits on who can contribute. Although there is no income limit for a traditional IRA, you can only contribute to a Roth IRA if your income is less than $183,000, or $193,000 if you’re filing with a spouse (as of 2015. These limits change from year to year). Finally, with a Roth IRA, you can leave the money in your IRA for as long as you’d like, while a traditional IRA requires that you start pulling out money when you’re 70 ½ years old.
What kind of limitations or penalties does an IRA have?
There is an annual limit on how much money you can put in your IRA; in 2015, the max is $5,500. Other restrictions vary according to the type of IRA you have. If you have a Roth IRA, you can take out your contributions (the cash that you put in there) for no penalty whenever you’d like. But if you take out money that the account has earned in investments before the age of 59 ½ and fewer than five years after you opened the account, you may owe taxes and a penalty on that money. If you withdraw money from your traditional IRA before you’re 59 ½, then you’ll pay a 10 percent tax penalty on the money, regardless of whether it’s the cash you originally put in or investment earnings.
You may be exempt from these penalties in certain situations. For example, you can withdraw money from an IRA without penalty if it’s going to pay for college, if you’re purchasing your first home, if you’re faced with unforeseen medical expenses, or have a disability that prevents you from working.
Should I get an IRA, even if I already have a 401K?
Some 401(k)s are better than others, but, in general, if you have a 401(k) that offers employer matching, you should invest in it (The matching is free money, after all!). Usually, an employer will have a maximum matching amount per year, so you should first put your money toward reaching that max and getting every bit of free money you can. However, once you’ve maxed out the employer’s matching, you may want to open an IRA as a supplement to your 401(k). An IRA will give you more control over your investments than your 401(k), and, if you get a Roth, you’ll be setting up a future in which you’ll have at least some funds available upon retirement that won’t be taxed.
Both 401(k)s and traditional IRAs work by letting you invest money without paying taxes (you pay taxes when you pull your money out at retirement); however, there are limits to how much you can put aside for retirement without incurring taxes at the outset. This means that if you have both a 401(k) and a traditional IRA, some of the cash you’re investing may not be tax deductible. (That shouldn’t be a problem if you get a Roth IRA, however, because you’ll pay taxes on that money at the beginning, and then forgo taxes later).
How do I get an IRA?
You can start an IRA at your bank, a mutual fund company, a brokerage firm, and a number of other financial institutions (There is also an option to have a self-directed IRA, in which you make the investment decisions). The type of institution you choose will affect what kinds of investments you make — mutual fund companies invest in mutual funds, banks invest in CDs and money market funds, insurance companies focus on annuities, and so on. Elizabeth Carlassare of the Money Girl podcast writes, “For most everyone, opening an IRA at a brokerage and mutual fund company makes good sense.”
When you talk to a representative about starting an IRA, be sure to discuss what kinds of fees may be involved and ask whether there is a minimum investment. Also consider practical questions like, How easy is the company website to navigate? Do they have good customer service? Can I do things with my investments online, or do I need to use the phone?
But I have student loan debt! How the hell can I save for retirement?!
Although you are absolutely justified in feeling unsure (and freaked out) about where to put your limited resources, you shouldn’t forget completely about retirement planning in favor of paying off debts. As a young person, you may not have loads of cash, but you do have the benefit of time — decades and decades ahead of you, when even small amounts of money could accrue significant amounts of interest. Of course, you need to be doing your best to lighten your debt, but squirrelling away a few hundred dollars here and there in an IRA now could really help you in the long run. Consider: Just 20 dollars a week — the price of four lattes, give or take — could contribute over a thousand bucks to your IRA every year.