Pete,
Some of my friends are opening Roth IRA accounts and telling me what a good idea they are. I understand how they’re different from a normal IRA account, and I think I’d like to open my own account, but I don’t know where to start. I’ve only got my 401(k) at work and I don’t know the first thing about opening an account like this. What should I do?
Jimmy
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Roth IRAs are a pretty fantastic tool for building wealth for retirement. What we need to make sure of is that you open a Roth account that you can manage confidently and consistently in the future. You may or may not end up with the same approach your friends are taking, but it will be the right option for you.
A quick primer for those of you who may not know the difference between Roth IRAs and Traditional IRAs:
A Roth IRA is an account that is funded with money you’ve already paid taxes on. If you are eligible to contribute to a Roth IRA (based on your income) your contributions will grow tax-free. Once you reach age 59 ½ you will be able to access those funds, both your contributions and the earnings/growth, without being subject to penalty or tax. Roth IRAs also allow the owner to take the contributions out of the account at any time without penalty and tax free.
A Traditional IRA provides a current-year tax benefit as opposed to the Roth IRA’s future tax advantage. A Traditional IRA contribution is deductible from your income in the tax year that you make it. That contribution will continue to grow inside of the account tax deferred. Once you reach age 59 ½ you can access the money but will need to pay income tax on that distribution (withdrawal).
Roth IRAs are funded with money you’ve already paid taxes on and won’t pay tax on when the money comes out. Traditional IRAs are funded with money you can deduct on your taxes this year but will need to pay tax on when the money comes out in the future.
There are some additional rules that determine who can make contributions and if the contributions are deductible and on and on, but this is the gist of it.
Now, your question: Opening an investment account is pretty simple even though it can seem intimidating. You only need a few bits of basic personal information to get started (name, address, social security number, bank info, etc.) and about 10-15 minutes of time. I think you’ll be surprised how easy it is to get an account established. It can all be handled online in a straightforward process. Should you run into trouble, the company you’ve chosen will have a customer service number that you can call for assistance. I don’t want you to think I’m overselling the simplicity of creating an account, but it really isn’t much more complicated than say, creating an Amazon account and making a purchase.
There is a bigger question here, though, and it needs your attention and honesty. This question is applicable to more than just a Roth account, too. Each of us needs to be aware of how we approach this question:
In other words, how much responsibility do you want to have in managing your account? The breadth of options available to the individual investor are quite a bit different than they were even a decade ago. Let’s look at the most common options a bit closer.
DIY Management - When most people think about opening an account, this is typically what they envision. This particular option may or may not be more complicated than you realize. You’ll be tasked with all parts of the investment selection process:
I mean, sure, most people don’t go through all of these steps when they open a Roth IRA to invest in, but they should. This process is a far cry from opening an account on Robinhood (or whatever the other 'flavor of the month' investing apps appear in the future), buying a stock, and then selling it a month later when it’s down 5%. This approach requires discipline and a bit of knowledge to work to its highest potential. You must be honest enough with yourself to recognize your abilities and, frankly, the time you want to devote to this process.
You can open this type of account with lots of companies. Vanguard, Fidelity, Schwab, TD Ameritrade, eTrade, etc. They’ll all be happy to get you set up with an account and offer you tons of different investment options to choose from.
KDIY Management - Kinda Do-It-Yourself Management looks quite similar to DIY Management but with considerably less time and effort spent on investment management. In this option you’ll use something known as a “target-date fund” (or something similar like “lifestyle funds”). Target-date funds are constructed to take the bulk of the decision making process off of the table for the investor. Let’s say you’re 25 and you’d like to retire at 65 which is 40 years from now. You’d look for a target-date fund with the year 2059 in its name. You’ll quickly discover there aren’t any target-date funds with 2059 in its name, so you’ll look for the next closest one which is 2060, in this case. Inside a typical 2060 target-date fund you’ll find around 5 other mutual funds as the holdings. Target-date funds function as a “fund of funds”. One mutual fund owns shares of multiple other mutual funds.
So, the investment selection is taken care of for you. Is that it? Not exactly. Target date funds will also change their holdings/allocations to become more conservative as the target-date approaches. This makes sense because you most likely won’t want to have the same amount of risk in your portfolio when you’re 64 as you do when you’re 34.
Investment selection? Check. Investment adjustments. Check. Target-date funds are kind of like a cake mix in a box compared to the DIY option. A mix from a box will get you the desired results with minimum fuss. A cake from scratch, though, could be way better… or worse, depending on your skill and effort. It’s important to know which is appropriate for you.
A Third Way - A new option became available for the individual investor beginning in 2010. This service model provides active investment management similar to what a client might receive when working with a professional investment advisor for a fee. The companies that offer this type of investment service are more commonly known as “robo-advisors.” Here’s how it works:
That’s it. The only thing you need to concern yourself with (for the most part) is making sure you’re consistently growing the account by funding it. It’s an incredibly simple process.
You may have noticed that I said this option is similar to what you’d get if you worked with an advisor and paid them a fee in the first paragraph. That’s true for how you’ll pay robo-advisors, too. You can expect to pay somewhere in the neighborhood of 0.25% of the value of your account value on an annual basis.
The robo-advisor space is growing quickly now that the business model is proving itself out. Companies like Betterment, Swell, Ellevest, Wealthfront, Acorns, and even Vanguard are making a name for themselves with their offerings. The minimum amount of money it takes to open an account varies from company to company, so make sure you check them out prior to starting the account opening process.
It’s important to note that none of these approaches, DIY, KDIY, or Robo-Advisors have guaranteed returns. When your money is invested in the market, the potential of losing account value and/or money is there.
One last thing, Jimmy. Before you start funding a Roth IRA, make sure you’ve got an emergency savings account established and funded. I know it seems pretty boring and pedestrian compared to contributing to a Roth account with investment options galore, but don’t underestimate the importance of an emergency fund. Many headaches and stressful situations can be prevented with having that extra cushion available to you. Start with the emergency fund first. You’ll never regret it.
Congrats on making the decision to start funding a Roth IRA, Jimmy. I know you’ll appreciate it come retirement time.
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