Whether you are self-employed or need a retirement savings account alongside an employee-sponsored 401(k), an individual retirement account (IRA) is a great option. At the same time, not all IRAs are created equal. Getting stuck with the wrong account can have significant tax ramifications for you, not to mention stunted growth potential.
There are several different types of IRAs, and they each play a different role depending on the degree of control you want over your investments and your ultimate goals for opening the accounts. Given the importance of these accounts in retiring with financial stability, it is worthwhile to do your homework before choosing the right one.
Deciding on the Best Type of IRA to Meet Your Financial Goals
The first thing that you need to do when choosing an IRA is to think about the type you want. Some IRAs are designed for specific circumstances, such as SIMPLE and SEP IRAs, both of which must be set up through a workplace. The government also offers its own form of IRA called myRA. While these specialty options can work for some people, the majority of us choose between a traditional or Roth IRA.
A traditional account works much like a traditional 401(k). You put your pre-tax earnings into the account and then pay taxes when you withdraw that money in retirement. Roth IRAs involve placing post-tax earnings in the account to avoid paying any taxes in the future.
The primary question is whether you want to pay taxes now or later. You will likely make less money in retirement, putting you in a lower tax bracket—but it’s not always the case.
Many people choose to open both kinds of accounts. You should also understand that money placed in an IRA, whether traditional or Roth, cannot be accessed until you turn 59 1/2 (unless certain circumstances for exceptions are met). Money withdrawn before that time is subject to a 10 percent tax penalty on at least part of the sum taken out, if not the whole amount. Therefore, you should avoid early withdrawals whenever possible.
Identifying the Type of Custodian That Meets Personal Needs
After figuring out the best type of account for your individual circumstances, you will need to figure out the right custodian for an IRA. Custodians are the organizations that actually administer the account, and the different options will have a large bearing on the performance of the account.
The four primary types of IRA custodians are banks, mutual fund companies, insurance companies, and brokerage firms. Each of these custodians offer different types of investments. Banks often offer certificates of deposit, while insurance companies may hold annuities. A mutual fund company typically offers exchange-traded funds, bonds, and stocks, and brokerage firms offer a full range of different options, although some may only be available at a premium.
When considering the right custodian, you will need to consider which options you want for your money. Sometimes, this decision changes over time. For example, people who are relatively close to retirement may be anxious about losing money through riskier investments and therefore may want to go with banks, which traditionally offer safer investments than other custodians. However, low risk often means slow growth. People who want accounts that need little oversight may prefer insurance companies because of the long-term, low-stress benefits of annuities. Brokerage firms may offer no-load options, or investments without sales charges or commissions—these are great for people who want to invest in the market.
Figuring out the Investments That Will Work for You
Once you choose the type of custodian that best meets your needs, you can start picking out investments. At certain custodians, the investment options are quite limited, so the decisions may not be too difficult. However, the options at brokerage firms and other custodians can be quite extensive.
When choosing investments, you should consider your overall goals, as well as your time left until retirement. Typically, people who are retiring within five to 10 years will want a rather conservative approach to avoid the risk of losing money. Those with more time can be more aggressive with their approach, but they should still avoid stepping outside of their risk comfort zone.
You may also want to think about the money you have in your account. In the beginning, when there is less money invested, you can afford to be more aggressive in your approach. After all, less money means that you will have less to lose.
When in doubt, do not be afraid to consult with a professional. A financial advisor can help you to figure out the right strategy based on your particular needs and situation, plus they can often point to some of the best IRA options. Importantly, they can also explain some of the common pitfalls involved in investing, which can help to ensure you do not get blindsided by risky investments or taxes.