What is an IRA?

When I graduated from college, my dad sat me down and explained that he wanted to help me open up a Roth IRA.

A what-now?

This did not sound like fun.

I figured anything that is named by a bunch of letters is usually complicated and when it comes to money, complicated is scary.

scared boy meets world

Basically me when I first heard the words “IRA”

As he explained what it was and how it worked, though, I started getting a little excited. And when I did my own research, I got a lot excited. Turns out, IRAs, particularly Roth IRAs, are pretty darn cool.

If you’re nervous about finances the way I used to be, it may sound crazy-pants to get excited by something that sounds both boring and confusing.

Fear not. I’m going to walk you through the important basics of IRAs and before you know it, you’ll be able to throw the term “IRA” around like you’ve always known what it means. You MIGHT even get a little excited.

Let’s get started.

What does IRA stand for?

IRA stands for “Individual Retirement Arrangement” although many people just say “Individual Retirement Account” because it makes more sense that way.

What is an IRA?

It’s a retirement account. This means it’s designed for you to put money in it, then invest that money in stocks and bonds, then sell those and take your money out gradually when you retire. Money in your retirement accounts is the money you will live off when you aren’t earning an income anymore.

Where can I open one?

You can open an IRA for yourself without going through an employer. Most brokerage firms, like Vanguard, Fidelity, Charles Schwab, and even E*Trade offer IRAs.

Who can open an IRA?

Anyone, including children, can open and put money into an IRA as long as they earn money somehow. It doesn’t matter whether you have a full-time job or if you babysit or shovel snow as a side gig, you can open an IRA as long as you earned some money and are reporting it to the government. No earned money? No IRA.

Parents can contribute to their child’s IRA as long as the contribution isn’t more than the child earned that year.

How many types of IRA exist?

There are four types of IRA, but we’re going to focus on the main two today: Traditional and Roth IRAs.

The Traditional IRA

The OG IRA.

You can put money into a Traditional IRA before you pay income taxes on it, so you avoid paying taxes on that money right now.

Instead, you pay the taxes when you withdraw the money in retirement. Anything you take out once you reach age 59½ will be taxed like income.

Taking anything out of the IRA before that time will cost you a 10% penalty.

The maximum amount you can put into this account per year (your “contribution“) is $5,500.

Traditional IRAs are great for when you’re making a really nice salary and are getting closer to retirement.

The Roth IRA

Roth IRAs are the best for young or lower-income people.

Roths allow you to put money into them after you’ve already paid the income tax on it, which means you pay taxes now.

However, all the money you pull out after age 59½ is tax-free, INCLUDING any money you make by investing what you put in (money you make with investments is called “gains“). Income that’s tax-free?! Yes, please.

If you need to, you can take out the money you put into a Roth IRA for free at any time. You CANNOT take out your gains before age 59½ without paying the 10% penalty, but at least you have access to some of the money in the account without having to pay extra. Not that you should ever take money from your retirement account before retirement, but it’s nice to know it’s there.

The maximum amount you can put into this account per year is $5,500.

Roth IRAs are great for when you aren’t making a ton of money because you pay smaller income taxes now and avoid paying taxes later.

PSST…if this is all a lot to take in, here’s a printable that lists these differences:

The ABCs of IRAs Printable

Which is better?

If you start your IRA early, the chances are good that you will make significant gains on that money, so a Roth is the better choice. Paying taxes on your lower income now will allow you to pull out a nice income during retirement without paying a dime of taxes on it.

As you get closer to retirement, Traditional IRAs often become the better option. The more money you make, the higher your taxes are. Most of us will make more as time goes on, and Traditional IRAs let you avoid paying heavy taxes on some of your income when you’re earning the most.

When you retire, as long as you pull less money out of your account than you used to make, you will pay less in tax than you would have using a Roth.

Confusing? Let’s look at some numbers.

Warning- Math Ahead

Let’s say you make $35,000 at the age of 20.

Using a Traditional IRA

In 2017, you would be expected to pay $4,784 in income tax. That’s not a fun number, so what if you contributed $5,000 of your salary to a Traditional IRA? Your income would now be taxed as if it were $30,000 instead.

That lowers your tax bill to $4,034, saving $750! Nice. If that $5,000 grows at about 5% for the next 30 years, even if you never add anything else to the account, you’d have $21,610 when you were 60 years old.

You could then pull out that money, but you’d have to pay $2,775 in tax when you pulled it out (assuming the tax rates are the same in thirty years!). That brings your total tax paid to about $6,809.

Using a Roth IRA

But let’s say you pay that $4,784 of income tax and then put $5,000 into a Roth IRA. You would make that same $21,610, but wouldn’t have to pay any tax on it when you used it at age 60, so you’d end up paying $2,025 less than you would by using a Traditional IRA.

If you contributed regularly to your IRA, you’d see this play out with much bigger, sexier numbers, but the basic idea is the same. As long as you can, you should contribute to a Roth IRA.

What’s the catch?

These IRA things are starting to sound pretty awesome, right? But, of course, there are some rules that limit how much we can take advantage of that awesomeness.

First, you can only contribute $5,500 per year to your IRAs, total. So, if you have both a Traditional and a Roth IRA, you can put part of that amount, say $2,500, into one, and the rest, $3,000, into the other, but you can’t contribute more than $5,500 between the two.

Also, Roth IRAs have income limits. This means if you make more than $118,000 as an individual, you aren’t allowed to contribute the full $5,500 to a Roth IRA until your income drops below that number again. Once you make more that $133,000, you aren’t allowed to contribute to it at all. Similar rules apply if you are married. For a chart that helps clarify what the income limits are for a Roth, check out Fidelity’s chart.

There are no income limits for a Traditional IRA, though, so if you are lucky enough to be making too much to put money in a Roth, contribute to a Traditional IRA instead.

Lastly, the early-withdrawal penalty I mentioned above can be painful if, for some reason, you HAVE to take money out of an IRA. All the more reason to set up an emergency fund.

Wrap-Up

The Benefits of IRAs

An IRA is a great way to stash away extra money for retirement. If you are already contributing to a work retirement account or if you don’t have an account through work, an IRA can help you stay on track to afford retirement.

Also, the fact that anyone earning income can contribute to an IRA means you can get a jump start on saving before you’re even in a full-time job.

The Potential Pitfalls

Like most retirement-specific accounts, IRAs have rules that punish you if you take money out too early. That doesn’t mean you CAN’T get to that money if you absolutely need it, but you may pay a 10% penalty for taking it out early.

There are exceptions to these rules, especially with a Roth, which is yet another point in its favor, but try to think of money in an IRA as off-limits.

And now you know the basics of an IRA! Congrats on making it through. As a reward, here’s a puppy in a cup!

chihuahua-dog-puppy-cute-39317.jpeg

Now, go open yourself a Roth and start stashing those extra dollars!

 

Disclaimer: None of the companies, apps, or websites mentioned in this article paid me to mention them.

What is a 401(k)?

Welcome back to our What Is? series of posts. Today, we’ll tackle an exciting topic with a snooze-fest name — the 401(k).

The term 401(k) may look like something out of Algebra class, but it’s actually one the most important perks any job can offer.

More important than free food and a foos-ball table?

Oh yeah.

What is this mysterious number-letter combo and why does it matter so much?

401 huh?

Very simply, a 401(k) is a type of retirement account. Retirement accounts are designed to help you save money while you’re working to live off after you retire.

The name “401(k)” comes from the section of the Internal Revenue Service (IRS) rules that defines the rules for this account.

As of this year, you are allowed to contribute any amount up to $18,000 a year to a 401(k).

What’s the big deal?

These accounts are awesome for several reasons.

Reason #1:

If you sign up for your employer’s 401(k), you can assign a percent of every paycheck to be automatically put into that account. This means that money is safely squirreled away where you’ll never miss it. You’ll be saving with basically no effort on your end.

Reason #2:

Your 401(k) contributions are taken from your salary pre-tax, or before your income taxes are taken out. This lowers your income in the eyes of the IRS, which in turn lowers the amount of money used to calculate your taxes. So, by contributing to your retirement, you could also be saving your current self some moolah in taxes. When you retire and start withdrawing that money from your account, you will have to pay income tax on it, but you won’t be working, so ya know, it’s still not a bad deal.

Reason #3:

Probably the best thing about 401(k) accounts is that employers who offer a 401(k) usually “match” a certain percent of your contribution. What does that mean? If your employer matches up to 3% of your 401(k), that means that the first 3% of your salary you assign to be put into your 401(k) will be doubled by your employer, so you are effectively contributing 6%. That money is in addition to your salary and won’t be taxed until you withdraw it.

Let’s look at some numbers.

Say you earn about $35,000, and you contribute 3% of your salary to your 401(k). That works out to be about $1,050 a year. If your employer matches that 3%, you’ll actually be getting $2,100 a year going into your retirement account.

If you contribute more than 3%, good for you, but your employer will only match that first 3%.

How amazing is that? You’re essentially doubling your retirement contribution by taking advantage of your 401(k) — free money!

free money simpsons

What happens to that money?

When you sign up for a 401(k), you will usually be given a list of funds that you can choose to invest your 401(k) money in. Once you’ve done your research and chosen a fund or two, your money will be invested and will start to work for you, growing even beyond what you are contributing.

Once you reach age 59.5, you will be able to start taking that money out of the 401(k). If you take it out before then, however, you will be hit with a 10% fee, so try to imagine that money as off-limits until retirement.

Other types of accounts

Some professions have retirement plans that are different from a 401(k). If you work for a non-profit or for the government, for example, your retirement accounts will have different names.

Teachers and non-profit employees are often offered a 403(b) plan — named, shockingly, after section 403(b) in the tax code — which allows similar contributions to an account. These accounts work differently from a 401(k), however. We won’t delve into them in this post, but the fees and rules around each type of retirement account can vary significantly, so educate yourself on what those are before signing up for any account.

Can I wait to open my 401(k)?

No. Why would you?

It’s a lot to think about when I’m starting a new job.

Better to get the paperwork out of the way when you’re filling out all the other forms for your job than put it off for some mythical future date when you’ll magically have time.

I’m making so little money! Won’t it be better to wait until I make more?

If you start right away, you’ll never miss the money that comes out of your check, and you’ll be taking advantage of your most valuable asset — time. The longer you give that money time to grow in your account, the more money you’ll end up with down the line.

What if I need every penny?

Even if your starting salary is tiny, try to assign at least a percent or two for retirement. That’s about $200 a year from a $20,000 salary, or $17 a month. You can do this.

Future-you will thank you.

Do I really have to invest?

First off, if you don’t know what I mean when I say “investing”, check out What is investing? and then come back.

All good? Okay.

Instead of jumping into why you should invest, maybe we should address some reasons people have for not investing.

1. It seems hard

Many things seem hard or confusing before you try them. Algebra is mysterious and complicated until you learn the basics of math that make it work. Foreign languages are nonsense until you learn the vocabulary and sentence structure. Investing is the same. Also, there’s no rule that says you have to become an investing genius. You just need to know enough to understand where you are putting your money, what it is doing there, and when you plan to take it out.

2. It sounds risky

I like to think of investing like skydiving. It’s a lot of fun, but there are many different levels of risk. Some people like to throw their money into risky situations, chasing the thrill of the big win but always risking the big fall. These are the base jumpers of the investing world. (Seriously, base jumping is crazy.)

Some people like to take some bigger risks, but in a more controlled and planned way. These are the people who skydive, and invest, solo.

Most of us, however, prefer tandem skydiving. This way, we can enjoy the thrill while firmly strapped to someone who knows the ropes and won’t let us get out of control. Investing with the help of a financial planner or at least some guidance from a broker is the best choice for many of us, and that’s okay.

The one thing we can’t do, however, is just sit on the ground and watch others jump out of planes. It sounds super safe, but you end up missing out on a huge opportunity, and will probably regret it later when everyone else is reaping the rewards.
Long analogy short, investing will never be completely without risk, but neither is life, and there are plenty of ways to minimize your risk and still invest.

3. I’m not rich

Investing is so tied to the idea of wealth in our culture that it’s tempting to to think that the ONLY people who can invest are those who already have oodles of money, which is simply not true, especially today. The internet has made it incredibly easy for anyone to invest.

Many brokerages allow you to open investment accounts with small amounts, and there are several apps that are designed to allow people to easily set aside little chunks of money to invest. We won’t get into them in this post, but for now, know that they exist and being wealthy already is absolutely not a requirement to be able to invest.

4. I don’t understand business

If you want to work on Wall Street or in business management, a business or finance degree will definitely help you out. But if you’re just investing for yourself, there’s no degree required.

You should still educate yourself on how to invest and what investments might be best for your situation and values, but modern investment tools and financial planners exist so that you DON’T have to be an expert. It’s important to be aware of what’s going on with your money, but you don’t have to invest alone.

But can’t I just use a savings account?

Having a savings account is important, but it’s not enough on its own. At some point, you’re going to have to invest.

I know it’s hard to think about spending $100 today on something you won’t get to enjoy for years, maybe decades. It’s the ultimate delayed gratification. However, as hard as it can be to set aside that money now, it’s pretty much the only way the average person making an average salary can hope to become a millionaire. Given enough time and a little luck, the $100 could turn into $500 or more down the line.

Still need convincing?

Let’s look at the math!

giphy

Don’t look at me like that, it’ll be fine.

The most recent U.S. Census Bureau data shows that the average household income in the United States in 2014 was $65,751. This includes both one- and two-income households. Let’s imagine you make exactly that amount. A very nice salary for a single person. (I’m going to ignore taxes for the sake of this math problem, FYI.)

According to the U.S Bureau of Economic Analysis, the average person saves about 5.7% of his or her income, which works out to about $3,748 a year for someone making the average household income.

If you socked that much away in a savings account every year for 30 years and got an average of 1.5% interest compounded monthly, you’d have saved about $147,767. Note that this interest rate is higher than you can get now, but may be lower than what you can get in the future.

Pssst. Did your eyes glaze over during that last paragraph? Need a refresher on compound interest? Hop on over to What is Compound Interest?

A six-digit bank account number is awesome, right? Except most people need from $800,000 to $1 million to retire comfortably today, and because of inflation it will probably be more by the time you’re old enough to retire.

giphy

Yeah, sorry to burst that bubble.

Of course, you might be able to save more than $3,748 a year, especially because you probably won’t make the same amount of money every year for 30 years, but where does a lot of the other $700,000 come from?

Yep. Investing.

Say you invested that same amount every year for 30 years and assume a reasonable 5% return. You’d end up with almost $250,000 in that account alone, according to the EdwardJones.com Investment Calculator.

Sounds good, right? A healthy combination of saving and investing will make retired-you very happy.

There are many ways to invest, and everyone’s investing style is a little different, but unless you plan to live as a hermit in the woods, you’re going to have to do it. No excuses.

Ready to start saving up to invest? Find out which of the four kinds of savers you are to help you get started!

What is investing?

Investing.

It sounds so big and grown up and scary. It’s the shadowy thing rich guys in movies do. Kids who talk about their “stock portfolio” on TV are supposed to be little geniuses. So of course, only the very smart or the very rich invest, right?

Nope!

Everyone, including you, can invest.

13ayi63wzvenpk

What does it mean to invest?

Investing, at its core, is simply buying something and expecting it to return something to you.

Most of the time, the return is money. Sometimes it’s something else.You and/or your parents might “invest” in your education, for example, because getting a degree will create a better future for you. The return your parents get is mostly the satisfaction they get from seeing you succeed. Your return might be a better job, salary, and stability.

For the purposes of this article, however, when I talk about investing I mean investing money with the goal of getting more money.

Will investing make me rich?

Overnight? Nope. Over time? Probably.

Here’s the deal. Despite what movies would have you believe, throwing some money in the stock market isn’t going to make you wake up tomorrow with a yacht, mansion, and more money than you can count. Unless you already have a yacht, a mansion, and almost more money than you can count. Then, maybe.

True investing is all about the long game. It’s about slowly adding to the money you have invested and watching your wealth build over time.

You’d be surprised how thrilling it can be just to know that you have some money working away in the background to make you more money. Really, how cool is that?

l2jhaeclzfefvpevu

Ways to invest

There are countless ways to invest your money. Here are three of the most common ways to invest and some essential facts you should know about them.

The stock market: The stock market is the classic place people think of when they think of investing. When you own shares of stock in a company, you own part of that company and hopefully profit from the success of the business.

The stock market can be a great place for young people, especially, to invest because it historically goes up over time, which means you make money over the years. It can be unpredictable in the short term, however, which is why people see it as scary.

The bond market: When you buy a bond, you are essentially loaning your money to the government or a company for a set period of time. That money gets repaid to you at the end of the agreed period of time, with interest.

Bonds are more predictable than stocks, but tend to produce lower returns. Traditional wisdom says the older you are, the more your investments should be in bonds. This protects your money from the fluctuations of the stock market while still giving you some guaranteed return.

Real estate: Real estate is property like land, houses, commercial buildings, etc. People will usually buy real estate hoping it will increase in value over time. The most common type of real estate for people to own is a place to live like a house or condominium.

Unlike when you buy stocks and bonds, you usually take out a loan, called a mortgage, to buy the property. Then, over 30 years or so, you pay that loan off. Real estate can be a good investment if property prices go up. It can also be a terrible one if those prices drop. Never invest in real estate without having a plan and research to back up your choice.

 

Most of us will invest in a mix of the three choices above over our lifetimes. You might decide to invest on your own, or maybe you’ll do it as part of a retirement plan at your workplace, or you could opt for a combination of both.

What is NOT an investment?

Anything that does not appreciate, or gain value, over time should not be called an investment. They are expenses. Some examples are:

Cars: A new car loses about 10% of its value the second it leaves the dealer, and the value of cars generally drops steadily over time.

Clothes/Accessories: No matter what brand name they are, used clothing, hats, and shoes are usually worth very little. On the plus side, if you are a brand junky, you can usually find gently used pieces for way below their new prices.

Diamonds: Sorry ladies (and gents). Diamonds are so not an investment. They may be beautiful, but as anyone who’s tried to resell one will tell you, you will never make money back on a diamond. This is true with most precious stones, but diamonds especially.

Gambling: Even though there’s a tiny, itty bitty chance you could win money from gambling, it is not an investment. Smart investments should always have a higher chance of return than loss, and gambling is ALWAYS rigged to favor the house. Always.

The exceptions to these are, of course, true collectors items or show pieces.
A car from the 1930s is worth a lot if it’s in great shape, for example. Before you go spending money on something you think will be a collector’s piece, however, make sure you do your research about the item and remember that nothing is guaranteed.

 

If you’re still confused or you want to know more, I’ll address a lot of the terms from this article in separate pieces. Investing does sound scary, but it doesn’t have to be complicated and you don’t have to be a millionaire to invest. However, investing can help you become a millionaire. Just not overnight.