An individual retirement account (IRA) is a type of tax-deferred retirement account. Opening one is a similar process to opening a brokerage account. Once an IRA is set up, investors can add funds manually or set up automatic contributions.
How to open an IRA in 4 steps
Investors can follow the following four steps to successfully open an IRA and begin (or supplement) their retirement savings.
Step 1: Choose an IRA account type
Setting up an IRA begins with choosing from one of three types of accounts. Each has its own eligibility requirements.
Contributions to a traditional IRA are made with pretax income. That means investors don’t have to pay income tax on eligible contributions in the year they are made. Rather, the account holder pays income tax on the funds when they withdraw them in retirement. There are no income limits for contributing to a traditional IRA, but an investor’s income tax deduction may be impacted if the individual or their spouse is also covered by an employer-sponsored retirement plan, like a 401(k).
Additionally, investors must wait until they turn 59 ½ before taking distributions; otherwise the withdrawn funds may be subject to a 10% penalty, in addition to state and federal income taxes.
Contributions to a Roth IRA are made with post-tax income. That means investors pay income tax on contributions when they’re made—but when the funds are withdrawn in retirement, they are tax-free.
However, investors must meet income limits to contribute. Single taxpayers can’t earn more than $125,000 for the maximum contribution in 2021. Those who are married and file jointly must earn less than $198,000 for the maximum contribution.
A SEP IRA is a type of tax-advantaged retirement account that is available to self-employed people or small business owners and their employees. An account may be opened by a self-employed individual, sole proprietor of a small business, or the owner of a small business with employees. Contributions are made with pretax dollars. Once the account holder reaches retirement age, they can start making withdrawals, which will be taxed as income.
However, if a business owner has or hires full-time employees, then equal contributions by salary percentage must be given to every employee who qualifies.
Step 2: Open your IRA account
There are many types of financial institutions where investors can open an IRA, including banks, brokerage firms, or robo-advisors.
Many people wonder, “Should I open an IRA with my bank?” It’s important to know that banks and credit unions typically offer IRAs through certificates of deposits. The account offers a low, and often fixed, interest rate. Those who wish to invest in things like individual stocks, exchange-traded funds (ETFs), and mutual funds can open an IRA through an online brokerage or robo-advisor.
Investors often compare financial institutions to find the best place to open a Roth IRA or other IRA types. There are several types of fees to be aware of when opening and maintaining an IRA, including:
- Account opening fee
- Trading and transaction fees
- Expense ratios for mutual funds and ETFs
- Advisory or management fee
In addition to opening an IRA and contributing funds, investors may also roll over 401(k) funds from a former employer into an IRA. This gives investors more control over available investments and administrative fees. Working with a rollover specialist from the new brokerage may help avoid accidental withdrawal penalties and taxes.
Step 3: Set up contributions
Another component of how to start an IRA is contributions. It’s important for investors to understand IRA contribution limits set by the IRS. In 2021, the contribution limit for both traditional and Roth IRAs for eligible investors is $6,000 each year. This applies to individuals younger than 50; investors 50 or older may contribute an additional $1,000 each year as a catch-up contribution.
SEP IRA contribution limits are higher. An individual may contribute up to 25% of their annual compensation, up to $58,000 in 2021.
Once an investor decides how much they wish to contribute each year, it’s time to choose a contribution schedule. Investors can contribute on their own schedule, say, with regular monthly transfers or a lump sum.
Monthly transfers can be automated so contributions are never missed. Additionally, this method allows for dollar-cost averaging when investing in stocks. This spreads out investments at multiple purchase prices as stock values fluctuate over time.
A once-a-year lump sum contribution allows investors to make a single payment into the account. If opening an account toward the end of the year, this strategy allows investors to take advantage of the full contribution limit before the tax year is over.
Step 4: Choose investments
Once an investor learns how to open an IRA, they can start investing. A portfolio can be built from some or all of the following components.
- Individual securities. This includes stocks and bonds. Some brokerages and robo-advisors allow investors to buy fractional shares, which is a portion of a share rather than the whole thing. This allows investors to gain exposure to higher priced stocks at any budget.
- Mutual funds. A mutual fund includes pooled investments that are actively managed by the fund manager. A mutual fund may include a diverse allocation of stocks and bonds. There’s typically an investment minimum, and investors can only sell the fund at the end of a trading day.
- ETFs. An ETF is similar to a mutual fund in that it is a collection of stocks. It trades as a stock and often comes with both a low minimum investment and low expense ratio. Trades may happen throughout the day. ETFs are passively managed, meaning the fund manager or algorithm does not typically buy and sell holdings on a regular basis.
- Index funds. An index fund is built to parallel a specific stock index, such as the S&P 500 or publicly traded small-cap companies. This type of fund is also passively managed to hold certain companies over the long-term.
- Target date funds. A target date fund may be structured as a mutual fund or an ETF. The portfolio’s asset allocation is built to adjust over time based on an expected withdrawal date. For instance, it’s a way for hands-off investors to plan for retirement based on the year they expect to stop working and start using those invested funds. College savings plans also use target date funds based on when the child beneficiary is expected to begin college.
Investors typically choose IRA asset allocations based on their risk tolerance and time horizon for using the funds. Portfolios can be crafted using a DIY approach or with the help of a financial advisor. Robo-advisors use algorithms to create IRA portfolio recommendations based on an investor’s specific situation and other investments.
The bottom line
IRAs are common savings tools for retirement. Opening one is a fairly straightforward process, similar to setting up a brokerage account. The difference is: Once funds are added to an IRA, they should stay there until retirement.