How to Set Up an IRA to Build Wealth

by Darren Wu on 19 March 2013 1 comment
Photo: Tax Credits

Here's some food for thought — if you save just under $11 a day in an investment that grows 8% each year, and in 40 years you'll have $1 million.

What would you do with a million dollars? Would you travel the world, visiting a new country every month? Support a cause that's dear to your heart?

How would you feel? More secure, knowing that you accomplished the goal of being able take care of most of your expenses?

To put this in perspective, you'll put in less than $150,000 of your own money, yet you'll end up with over six times that amount. That demonstrates the time value of money and the incredible power of compound interest.

And it gets even better. An IRA is a great place to do all your saving, because you'll get some nice tax benefits — benefits that'll put even more money in your pocket.

Let's get started. Here's how to set up a wealth building IRA in four simple steps. (See also: Choosing a Retirement Account: What's Available, and What's Best for You?)

Step 1: Traditional or Roth?

There are two types of IRAs, and the first step you need to take is to decide which one of the two you want to open — a Traditional or Roth IRA.

What's the difference between the two?

With a Traditional IRA, your withdrawals at retirement are taxed, but your yearly contributions are tax deductible. This means that if you contribute $5,500 every year and you're in the 25% tax bracket, you'll also save $1,375 in taxes every year.

With a Roth IRA, you contribute with after-tax money, but your withdrawals at retirement are tax free. This means that if you retire with $1 million, you won't have to pay taxes on a single penny of that $1 million.

Which one should you choose?

If you're just starting out in your career and have a relatively low salary, it may make more sense to pay taxes now while you're still in a low tax bracket. In this case, choose the Roth IRA.

But if you're making the big bucks and you're at the height of your earnings potential, you'll probably be in a lower tax bracket in retirement. In this case, choose the Traditional IRA.

There may be other factors that come into play when deciding between the two, but the guidelines above provide a good starting point. If you want help making a more informed decision, check out the IRS's guide to IRAs.

Step 2: Which Company?

Once you decide which type of IRA is best for you, the next step is to decide which company you want to invest with. The main things you want to look for in a company are:

  1. The availability of good mutual funds
  2. Low fees
  3. Low minimum opening requirements

Several reputable companies meet these three criteria. Two of the well-known ones are Vanguard and Fidelity. As such, they're the ones I'll be referring to in more detail below.

ARTICLE CONTINUES BELOW

Step 3: Which Fund?

After you decide which company you want to invest with, the next step is to choose your investment. There are several ways to invest, and several types of investments to consider.

But I'll share with you the two methods that experts in the personal finance community suggest. These methods will save you money and build more wealth.

Hands-Free Funds

The first method is for those of you who want to stay hands-off, yet still earn a good return on your money. If you don't want to actively monitor your investments, then target date retirement funds are for you. Just pick the fund with the year closest to the time you want to retire, and you're good to go. Set it, and forget it.

  • Fidelity Freedom Funds have a $2,500 minimum in order to open an account. They come with expense ratios between 0.44% and 0.76%.
     
  • Vanguard Target Retirement Funds have a lower minimum, requiring just $1,000 in order to open an account. They're also cheaper to own, with expense ratios just between 0.16 % and 0.18%.

Hands-on Funds

The second method is for those of you who want to be more hands-on and pay less in fees. If you want to reduce your costs of investing, consider building a portfolio that you manage yourself.

  • Most Fidelity index funds have a $2,500 minimum, and expense ratios between 0.10% and 0.34%.
     
  • Most Vanguard index funds have a $3,000 minimum, and expense ratios between 0.18% and 0.24%. By buying a few different funds at different dollar amounts, you'll end up paying less in fees.

If you'd like to see an example of how I do it, check out the Core Four Portfolio.

Step 4: Contribute Regularly

After you've chosen your investment, the last — and most important — step is to contribute to your IRA on a consistent basis.

Remember that million dollar example at the beginning of this post? For the time value of money and the magic of compounding to work for you, you need to invest regularly. Fortunately, this is simple to do.

Just like you can invest in your 401k automatically every two weeks through direct deposit from your paycheck, you can also automatically invest in your IRA in the same way. By setting up automatic transfers from your checking account to your IRA, you'll build wealth with much less effort.

Remember, just $11 a day can deliver a million dollars your way.

When will you set up an IRA and begin building wealth?

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You should note more clearly that there are annual contribution limits and, depending on your retirement plan coverage at work and income, traditional IRA contributions may not be tax deductible. In that instance, high earners are better off contributing to a 401(k) instead.