For our first installment in our retirement series we had a hard time choosing where to start. Retirement for many people can be daunting, especially for millennials thinking it is impossible to see that far into the future. Because tax season is upon us, we settled on talking about IRAs. The Bonus? There is still time to contribute into your 2016 IRA before the April 15th tax deadline.
Let’s start out simple. What exactly is an IRA? IRA stands for individual retirement account. An IRA is essentially a tax advantaged account you put money into with the intention to use the balance when you retire.
If you are thinking, I’m too young to think about retirement, then go to the bathroom, turn the shower on cold and jump in because you need a wakeup call. You are never too young to think about retirement. In fact the younger you start investing for retirement the less you have to save with your own cash. Being young gives you the advantage of compounding interest over a very long time.
Alright, well let’s get back to the IRA… There are two main types of IRAs, Traditional and Roth. They work similar to Traditional and Roth 401K’s…(assuming you have an idea what those are too).
The traditional IRA is tax deductible when you contribute, and when you retire you must pay income tax on the money you take out.
In a Roth IRA you pay normal income taxes on the money going into the account but when you retire you do not pay taxes when you withdraw money.
Depending on your particular situation one may be better than the other. We will get to that later on.
How much can I contribute to an IRA?
The maximum you can contribute to an IRA in is $5,500 per year. This is the total amount even if you have multiple IRAs or a mix of a Traditional IRA and a ROTH. If you are married both you and your spouse can contribute up to the max for a total of $11,000 per year. You can only contribute earned income to an IRA, so you cannot open an account for your infant child and deposit money into it. If your spouse does not work however the working spouse can contribute money in their IRA.There are income limits if you are allowed to contribute to a Roth IRA and there are income limits too if a traditional IRA will be tax deductible. So if you and your spouse are high earners check the IRS website here and here.
I have a 401k I don’t need no stinkin IRA.
Yes, you might have a 401k which is great, but you should also have an IRA. There are several good reasons why you should have both accounts, even if you are not maxing the $18,000 per year contribution limit in your 401k. Let’s start first. If your employer offers any sort of match in the 401K plan then yes by all means always, always, always contribute to get the full match. It is literally free money. The best way to think of it is if your employer offers a 100% match up to the first 3% then if you contribute 3% of your income to your 401K you get a total of 6% invested. This is like automatically getting 100% interest gain. Now once you have contributed to get the full match it might be time to look at a IRA instead of putting more in your companies 401K.
Since IRAs are opened individually then you can pick any investment firm you would like. You don’t get to choose your 401k provider and there are many 401ks that just plain stink. One of the greatest benefits of an IRA is you typically have access to many more investment options and different types of mutual funds. Even better, your IRA stays with you no matter what job you have.
If you like simple investing and don’t really care about what ETF or mutual fund your money is in then probably the greatest advantage of an IRA is expense ratios.
What is an expense ratio you ask?
Well an expense ratio is the annual fee that all ETF and Mutual funds have to cover the operating expenses. Each fund you choose in your 401K will have an expense ratio associated with it. The average 401K funds will have an expense ratio of about 1% but I have seen some that go into the 2% range as well. At 1% for every $10,000 invested $100 will be taken from your account. In an IRA you can easily find expense ratios of 0.18%. You may be thinking, why do I care about a less than 1% difference? Well, again we come back to compounding interest and with being young millennials compounding interest has even more effect because we will be investing over a longer period.
Let’s look at a real world example to see how much you could save by investing in an IRA vs a 401K.
Let’s take two options, Option A is we open an IRA and invest the maximum 2017 contribution amount of $5,500 in a fund with a 0.18% expense ratio and Option B we invest an extra $5,500 in a 401K with a 1% expense ratio.
After the initial investment we continue to add $5,500 into our IRA every year for option A or we put an extra $5,500 in our 401K every year for option B. We assume since we are young we can let the money sit for 40 years before we retire. Not a bad calculation considering we our in our mid 20s and full retirement age for social security is 67.
We invest both in a ETF that tracks the S&P 500. (If you don’t know what the S&P 500 is, it is a stock market index of 500 large companies). Now the average rate of return from the S&P 500 from 1928 through 2014 is about 10%. Keep in mind the stock market has its ups and downs so you won’t see 10% every year but averaged over 40 years we should see pretty close to that. To make our calculation even simpler we don’t want to deal with inflation so we will take an average rate of return of 7% instead of 10%. This gives us the average rate of return that is adjusted for inflation. To put it simpler, we look at our money after 40 years, looking at dollar amounts that are worth the same as they are today because we adjusted our return for inflation.
I saved myself over 237 thousand dollars by opening an IRA instead of contributing more to an 401K. That’s a lot of cash, $$$, or moola!
I am a Federal Employee with a TSP (Thrift Savings Plan) Do I want an IRA?
The TSP is one of the greatest benefits to federal employees. If you are not aware it is essentially a 401k but with expense ratios of 0.038%. Yeah you read that right. This is pretty much the best you will find in the industry, so why would I want a IRA? Well you might not, but a TSP only has 5 main funds to choose from and a few target date funds. It doesn’t have a good international stock exposure so you are really limited. An IRA would open 1000s of different types of fund choices.
Alright, I’m convinced. Where do I open an IRA?
Vanguard, Fidelity, or Charles Schwab are all great places that are known for low expense ratios. We personally use Vanguard as they tend to have the lowest expense ratios in the industry. They offer target date retirement funds with 0.16% expense ratios. (Yeah even less than our example)
Finally I will leave you with this…
Roth or Traditional?
This is a loaded question but here are a few rules of thumb that might help you decide.
- Open a Traditional if
- You are in a high tax bracket already
- You don’t expect pension or other retirement income.
- You think taxes will be lower in the future.
- You currently live in a state with state income tax and plan to retire in a state that does not have state income tax.
- Open A Roth if
- You exceed the income limit to deduct a traditional IRA from your taxes
- You are currently in a low tax bracket
- You expect a lot of other retirement income such as a pension and social security.
- You think tax rates will be higher in the future
- You currently don’t pay state income tax and might retire in a state that has state income tax