Image source: Getty Images.

An individual retirement account (IRA) can be a fantastic tool for saving for retirement. You don't need much to get started, as many have no minimum investment requirements. Whether or not you should open an account depends on factors like your income, savings, and other retirement accounts.

Here's how to decide if you should open an IRA, and how to do it, in eight simple steps.

1. Are you maximizing your 401(k) match at work?

If you don't have access to a 401(k) with an employer match, then this isn't a consideration. If you do have access to a 401(k) with a match, then read on.

Employers may offer a wide range of matches on their workers' 401(k)s, from no match at all to 100%. The most common match is 50%, up to a certain dollar amount or percentage of your income. So the most common match would give you an extra $0.50 for every $1 you contribute to the plan until your savings reach a certain threshold. A Vanguard study released in 2016 suggested that the median maximum employer match was equal to 3% of employee salaries.

Employer matches are literally free money. Before you even think about opening an IRA, make sure you're getting the most of your employer match. It makes little sense to put $1,000 into an IRA if you could put $1,000 into a 401(k) and have it matched with another $500 from your employer. After all, that's an instant return of 50% on your investment, which is virtually unbeatable.

2. Have you paid off your high-interest debt?

Over the full history of the American stock market, returns have averaged about 9% annually. This isn't to say that it was a smooth 9% -- stocks go up and down in value, often for long periods of time in either direction -- but it's a good benchmark for understanding what investors might earn from stocks over the very long haul. It also far outpaces the growth of other traditional asset classes.

Yet some people can achieve even better "returns" by paying off their high-interest debt. The average credit card balance in this country compounds at a rate of 13.8% per year. Paying that off is like getting a guaranteed double-digit return each year. In fact, it's even better when you consider that credit card interest isn't tax-deductible, unlike mortgage or student loan interest.

If 13% per year doesn't sound like much, consider that fewer than one out of 1,000 mutual funds earned that kind of return in the last 10 years. Chances are you won't be able to pick the fund that generates extraordinary returns in the future. But you can get a guaranteed return by paying down debt.

3. Do you have three to six months' worth of expenses saved up?

When you need money the most, it's frequently the most expensive to come by. Plenty of otherwise responsible people cashed out of retirement accounts at the absolute worst time, selling stocks at a third of today's prices during the depths of the 2008 financial crisis. That bad decision was only compounded by the fact that they probably paid penalties to the IRS for emptying their retirement accounts.

Don't put yourself in that situation. Before saving for retirement, you should have three to six months of living expenses stored away in an emergency fund -- somewhere you won't touch it unless you really truly need it.

4. Congrats: You're ready to open an IRA!

If you answered "yes" to the questions above, then you can responsibly open an individual retirement account. Now you need to decide what kind of IRA you want to open. But don't be overwhelmed, and certainly don't overthink it.

Your two options are as follows:

  1. A traditional IRA, which allows you to invest pre-tax income. You'll pay taxes on your withdrawals in retirement.
  2. A Roth IRA, which allows you to invest taxed income. Your withdrawals will be tax-free in retirement.

The important factor in deciding between a traditional or Roth IRA is how your current marginal tax rate compares to the tax rate you expect to pay during retirement. 


Roth IRA

Traditional IRA

You expect to pay a higher tax rate in retirement

You expect to pay a lower tax rate in retirement

Of course, it's impossible to know exactly what the future holds.

If you are a young person working for minimum wage, then go with a Roth IRA. You'll almost certainly be in a higher tax bracket at retirement. If you're 55 years old and plan on retiring at 62 thanks to early Social Security payments and pension income, then you can make a much more informed decision about your income today versus what you can expect in retirement.

Roth IRAs are subject to income limits of $117,000 for single people and $184,000 for joint filers. That said, there's a way around those income limits. Any American with earned income, no matter how high it is, can contribute money to a traditional IRA and then roll it over to a Roth IRA in what's known as a "backdoor" Roth contribution. Note, however, that any funds converted from a traditional IRA to a Roth IRA will be taxed.

5. How to open an IRA

Opening an IRA has never been easier. Virtually every online broker and respectable fund company can get you set up online in a matter of minutes.

Don't have a lot of money to get started? That's not a problem. In an effort to win over customers, most brokerages have no minimums, or they waive them for people who agree to make automatic monthly contributions. Charles Schwab, TD Ameritrade, Fidelity, and Vanguard all offer you the opportunity to open an account with as little as $1.

I prefer Vanguard because it is owned by its investors in much the same way credit unions are owned by their depositors. It also has a number of extremely low-fee funds with which you can build a diversified portfolio of stocks and bonds from all around the world. Some investors prefer other brokers, though; it's a personal decision.

I do have just one rule that I think everyone should live by: Avoid custodial fees -- i.e., fees you pay simply for having an account. You can avoid custodial fees and other maintenance charges at any of the aforementioned companies by agreeing to receive statements and other documents electronically. They save on paper and postage and happily waive fees for people who help them save money.

To open an IRA, you'll just need your name, address, date of birth, and Social Security number. It also helps to have a bank account from which you can make a transfer to open the IRA and make routine electronic deposits. You don't technically need a bank account to open an IRA, but you should have one -- bank accounts make everything much easier. 

6. Making your first deposit

You can deposit money into your IRA either electronically by entering your bank account information (ACH transfer), writing a check, or wiring the funds. As a general rule, ACH transfers are the best choice because they're easy, quick, and free. Frequently, an ACH transfer is also the only way to make a deposit without paying a fee to do so.

How much you can contribute in any given year depends on how old you are. In 2016, the contribution limits are $5,500 for people younger than 50 years of age, and $6,500 for people who are aged 50 or older. It doesn't matter whether you have one IRA or 50 IRAs; the most you can contribute in total is $5,500 (or $6,500) in 2016.

7. Making your first investment

An IRA isn't an investment. It's an account that holds investments. Once you have money in your IRA, you need to decide what to invest it in.

Mutual funds can be a great way to build a diversified portfolio even if you don't have a lot of money to invest. When you buy a share of a fund, you own a small piece of its portfolio, which can be made up of thousands of different stocks and bonds.

A common rule of thumb for deciding what to invest in is to subtract your age from 100 and invest that percentage of your portfolio in stocks. So if you're 30 years old, then you should invest 70% of your account in stocks (100 - 30 = 70) and put the remainder into lower-risk bonds. If you're fairly confident and comfortable with risk, then you can subtract your age from 110 for a higher-growth portfolio.

Mix of Stocks and Bonds

Annualized Returns From 1926 to 2015

100% bonds


30% stocks and 70% bonds


50% stocks and 50% bonds


70% stocks and 30% bonds


100% stocks


Data source: Vanguard.

When selecting funds to invest in, remember that the single greatest predictor of a fund's future performance is how much you pay to own it.

Low-fee index funds can be a great way to start. Index funds buy hundreds or thousands of stocks and bonds to essentially give you the average return of the index they track. Keep in mind that average is not bad. Again, the S&P 500 index of large companies has returned 9% on average, which is enough to double your money in eight years.

Companies in the S&P 500 index make up about 80% of the stock market's value. If you own an index fund that tracks S&P 500 index, then your return will closely mirror the returns of American stocks over time.

Here are a few low-cost S&P 500 index funds:

Another popular stock index is the Total Stock Market Index, which invests in almost every single company listed on American stock exchanges. Companies in this index make up 99.9% of the stock market's value.

Here are some low-cost total stock market index funds:

For bond funds, the Aggregate Bond Index (basically a total bond market index) can be a great choice. Others prefer just to invest in super-safe, short-term government bonds to balance out the risk of their stock funds by buying a U.S. Treasury Bill index fund. Here's an example of a low-cost fund for each option:

Warren Buffett, one of the greatest investors of all time, said he plans to leave his wealth invested in a simple portfolio of S&P 500 and government bond funds when he passes away. If that strategy is good enough for Buffett's legacy, then it's probably good enough for your retirement savings.

8. The hardest part

Resist the temptation of tinkering with your IRA. When you have money in the market, it's easy to let the market's frequent swings seem more important than they really are.

"But the market dropped 10%!" you say.

That happens once every 11 months, on average. Go live your life just as you always have. Better yet, commit to investing more money automatically every two weeks.

"But doing nothing is boring!"

It can be, sure. But the truth is that investors who do nothing experience much better returns than people who trade more frequently. In fact, returns are negatively correlated with activity: The more you change your mind, the more it costs you in lost returns. The hardest part about investing for retirement is doing nothing at all.

If you've made it to the end of this article and you feel you're ready to open an IRA, then don't wait. Start saving for your future and enjoying those tax benefits right now.