How To Start An Individual Retirement Account (IRA)

Quick answer

• An IRA is a tax-advantaged investment account for retirement savings.
• You can open an IRA at most major brokerages or banks.
• Decide between a Traditional IRA (pre-tax contributions) or Roth IRA (after-tax contributions).
• Determine your investment goals, risk tolerance, and time horizon.
• Fund your IRA and choose investments like stocks, bonds, or mutual funds.
• Regularly review and rebalance your portfolio as needed.

What to check first (before you invest)

Time Horizon

Your time horizon is how long you have until you need to access the money, typically for retirement. A longer time horizon generally allows for more aggressive investment strategies, as you have more time to recover from market downturns. For example, someone in their 20s has a much longer horizon than someone in their 50s.

Risk Tolerance

Risk tolerance refers to your comfort level with potential investment losses in exchange for higher potential gains. If market swings cause you significant stress, you might have a lower risk tolerance. This will influence the types of investments you choose.

Emergency Fund

Before investing for retirement, ensure you have a solid emergency fund. This fund, typically holding 3-6 months of living expenses in a readily accessible savings account, prevents you from having to withdraw from your IRA prematurely for unexpected costs like job loss or medical bills.

Fees and Tax Impact

Understand the fees associated with your IRA and investments. These can include account maintenance fees, trading commissions, and expense ratios for mutual funds and ETFs. Also, consider the tax implications of Traditional vs. Roth IRAs. Contributions to a Traditional IRA may be tax-deductible now, while withdrawals in retirement are taxed. Roth IRA contributions are made with after-tax money, and qualified withdrawals in retirement are tax-free.

Account Type

Decide which IRA type best suits your situation. A Traditional IRA might be beneficial if you expect to be in a lower tax bracket in retirement than you are now. A Roth IRA is often preferred if you believe you’ll be in a higher tax bracket in retirement or want tax-free income later. You can also have both, up to the annual contribution limits.

Step-by-step (simple workflow)

1. Determine your IRA type: Decide if a Traditional or Roth IRA is a better fit for your current and expected future tax situation.

• What “good” looks like: You’ve considered your current income, expected future income, and tax bracket.
• Common mistake: Not understanding the tax implications of each type.
• How to avoid it: Read up on the differences or consult a tax advisor.

2. Choose a financial institution: Select a brokerage firm, bank, or mutual fund company to open your IRA with.

• What “good” looks like: You’ve compared institutions based on fees, investment options, and customer service.
• Common mistake: Picking the first option without research, leading to higher fees.
• How to avoid it: Look for institutions with low or no account fees and a wide range of investment choices.

3. Open your IRA account: Complete the application process, which usually involves providing personal information.

• What “good” looks like: Your account is successfully opened and ready for funding.
• Common mistake: Providing incomplete or inaccurate information, delaying the process.
• How to avoid it: Have your Social Security number, address, and employment information readily available.

4. Fund your IRA: Transfer money from your bank account or other sources into your new IRA.

• What “good” looks like: You’ve deposited funds that align with your savings goals.
• Common mistake: Not funding it consistently or at all, missing out on growth.
• How to avoid it: Set up automatic transfers from your checking account.

5. Select your investments: Choose assets like stocks, bonds, mutual funds, or ETFs to hold within your IRA.

• What “good” looks like: You’ve selected investments that match your risk tolerance and time horizon.
• Common mistake: Investing in overly complex or risky products without understanding them.
• How to avoid it: Start with diversified, low-cost index funds or ETFs.

6. Set up automatic contributions (optional but recommended): Automate regular deposits to ensure consistent saving.

• What “good” looks like: You’re contributing regularly without having to think about it.
• Common mistake: Waiting to invest large sums sporadically, leading to missed opportunities.
• How to avoid it: Treat IRA contributions like any other recurring bill.

7. Monitor your investments: Periodically review your portfolio’s performance.

• What “good” looks like: You’re aware of how your investments are doing and if they still align with your goals.
• Common mistake: Checking too often and making emotional decisions based on short-term market fluctuations.
• How to avoid it: Schedule quarterly or semi-annual reviews.

8. Rebalance your portfolio: Adjust your investment mix back to your target allocation as market performance shifts it.

• What “good” looks like: Your portfolio’s risk level remains consistent with your plan.
• Common mistake: Letting your portfolio become too heavily weighted in one asset class.
• How to avoid it: Rebalance when your asset allocation drifts significantly from your target.

Risk and diversification (plain language)

• Diversification is like not putting all your eggs in one basket. If one investment performs poorly, others might do well, cushioning the overall impact. For example, investing only in tech stocks is riskier than investing in a mix of tech, healthcare, and consumer goods companies.
• Asset allocation is about balancing different types of investments. This typically includes stocks (higher risk, higher potential reward), bonds (lower risk, lower potential reward), and cash equivalents. The right mix depends on your age and risk tolerance.
• Stocks represent ownership in a company. They offer the potential for growth but can be volatile. Think of buying a small piece of Apple or a local business.
• Bonds are loans you make to governments or corporations. They generally offer more stable income but lower growth potential than stocks. It’s like lending money to your city for a new park.
• Mutual funds and Exchange-Traded Funds (ETFs) are baskets of investments. They offer instant diversification by pooling money from many investors to buy a variety of stocks, bonds, or other assets.
• Index funds are a type of mutual fund or ETF that tracks a specific market index, like the S&P 500. They are often low-cost and provide broad market exposure.
• Market volatility is normal. Stock markets go up and down. It’s a natural part of investing.
• Long-term perspective is key. Historically, markets have recovered from downturns and grown over the long term.

During market drops, it’s crucial to stay calm and stick to your investment plan. Avoid making impulsive decisions to sell. Often, market downturns present opportunities to buy assets at lower prices, especially if you have a long time horizon. Rebalancing can also help you capitalize on these dips.

Common mistakes (and what happens if you ignore them)

Mistake	What it causes	Fix
Not opening an IRA at all	Missed opportunities for tax-advantaged growth and significantly lower retirement savings.	Start now, even with small contributions. The sooner you begin, the more time your money has to grow.
Not understanding Traditional vs. Roth IRA	Paying more in taxes than necessary throughout your life or in retirement.	Research the differences or consult a tax professional to determine which best suits your situation.
Contributing more than the annual limit	Potential penalties and the need to withdraw excess contributions, which can cause tax complications.	Know the IRS annual contribution limits for your age group. Check the IRS website or your brokerage for current figures.
Investing too conservatively for your age	Insufficient growth to meet retirement goals, potentially leading to a lower standard of living in retirement.	Gradually increase risk as you get younger, focusing on growth-oriented investments like diversified stock funds.
Investing too aggressively for your age	High risk of significant losses close to retirement, potentially jeopardizing your ability to retire on time.	Shift towards more conservative investments like bonds and stable value funds as you approach retirement age.
Not diversifying investments	Higher risk of substantial losses if one particular investment or sector performs poorly.	Invest in broad-market index funds or ETFs that hold a wide variety of assets across different industries and geographies.
Making emotional investment decisions	Buying high out of FOMO (fear of missing out) and selling low out of panic, eroding returns.	Develop a written investment plan and stick to it. Avoid checking your portfolio daily; focus on long-term goals.
Neglecting to rebalance your portfolio	Your asset allocation drifts, making your portfolio riskier or less growth-oriented than intended.	Schedule regular rebalancing (e.g., annually) to bring your portfolio back to your target asset allocation.
Failing to understand investment fees	Fees erode your returns over time, significantly reducing your accumulated wealth.	Choose low-cost index funds and ETFs. Be aware of account maintenance fees and trading commissions.
Withdrawing funds before retirement age	Steep penalties (usually 10% early withdrawal penalty) and ordinary income taxes on the withdrawn amount.	Build and maintain a separate emergency fund. Understand the rules for penalty-free withdrawals if absolutely necessary.

Decision rules (simple if/then)

• If your income is high and you expect to be in a lower tax bracket in retirement, then consider a Traditional IRA because contributions may be tax-deductible now.
• If you expect your tax bracket to be the same or higher in retirement, then consider a Roth IRA because qualified withdrawals are tax-free.
• If you have a long time horizon until retirement (e.g., 20+ years), then you can generally afford to take on more investment risk because you have time to recover from market downturns.
• If you are close to retirement (e.g., within 5-10 years), then you should consider reducing your investment risk by shifting towards more conservative assets like bonds.
• If you are unsure about managing investments, then start with low-cost, diversified index funds or ETFs because they offer broad market exposure with minimal effort.
• If you have a significant amount of debt (like high-interest credit cards), then paying down that debt might be a higher priority than investing in an IRA, as the interest saved can be a guaranteed return.
• If you have an employer-sponsored retirement plan like a 401(k) and your employer offers a match, then prioritize contributing enough to get the full match before opening an IRA, as that’s free money.
• If you receive a bonus or unexpected windfall, then consider contributing it to your IRA to accelerate your retirement savings and benefit from tax advantages.
• If you experience a significant life change (e.g., marriage, new job), then review your IRA strategy to ensure it still aligns with your updated financial situation and goals.
• If you are self-employed or a small business owner, then explore options like a SEP IRA or Solo 401(k) which may allow for higher contribution limits than a Traditional or Roth IRA.

FAQ

What is an IRA?

An IRA, or Individual Retirement Arrangement, is a type of investment account designed to help you save for retirement with tax advantages. You can contribute to an IRA regardless of whether you participate in an employer-sponsored retirement plan.

What’s the difference between a Traditional IRA and a Roth IRA?

In a Traditional IRA, contributions may be tax-deductible now, and withdrawals in retirement are taxed as ordinary income. In a Roth IRA, contributions are made with after-tax money, and qualified withdrawals in retirement are tax-free.

How much can I contribute to an IRA each year?

The IRS sets annual contribution limits for IRAs. These limits can change year to year and may be higher for individuals age 50 and over. Check the official IRS website or your brokerage for the current limits.

Where can I open an IRA?

You can open an IRA at most major brokerage firms, banks, and mutual fund companies. Many online platforms offer user-friendly interfaces and a wide range of investment choices.

What can I invest in within an IRA?

You can typically invest in a wide variety of assets, including stocks, bonds, mutual funds, ETFs, and money market funds. Some IRAs may also allow for alternative investments, though this is less common.

When can I withdraw money from my IRA?

Generally, you can withdraw money penalty-free starting at age 59½. Withdrawals before this age may be subject to a 10% early withdrawal penalty, in addition to ordinary income taxes, unless an exception applies.

Do I have to invest the money myself?

While you can choose to invest the money yourself, many IRA providers offer managed portfolios or robo-advisor services that can select and manage investments for you based on your goals and risk tolerance.

What happens if I don’t use all the money in my IRA by retirement?

Traditional IRAs have Required Minimum Distributions (RMDs) that begin at a certain age, meaning you must start taking money out. Roth IRAs do not have RMDs for the original owner.

What this page does NOT cover (and where to go next)

• Specific investment recommendations for stocks, bonds, or funds.
• Detailed tax advice or estate planning strategies related to IRAs.
• Rules for specific IRA types like SEP IRAs, SIMPLE IRAs, or Inherited IRAs.
• How to manage investments during periods of high inflation or economic recession.
• The process of rolling over an old 401(k) into an IRA.