Published in: Buying Stocks | Dec. 16, 2018
5 Reasons to Open an IRA Account Right Now
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An individual retirement account, or IRA, can be a great way to build a nest egg for retirement. However, many Americans don’t fully understand the unique benefits of IRA investing -- that is, what makes an IRA better than a savings account or a standard brokerage account?
With that in mind, here are five of the most compelling reasons why you should consider opening an IRA, and why you should do it as soon as possible.
A great tax benefit now (or later)
The most obvious reason to open an IRA is for the tax benefit. If you choose to contribute to a traditional IRA, you may be able to take a deduction for your entire contribution -- up to the IRS’s annual limit. Alternatively, if you choose to open a Roth IRA and qualify to make a contribution, any qualified withdrawals from the account will be 100% tax-free, no matter how much your investments grow.
It’s also important to point out that your contributions don’t necessarily have to be made before the end of the year. You have until the tax deadline to make your contributions and take advantage. For example, if you want to contribute the $5,500 maximum to a traditional IRA for 2018, you have until the April 15, 2019 tax deadline to get your contributions in.
Lots of investments to choose from
One of the most common questions I hear as a financial planner is, “Should I put money in an IRA, or just contribute more to my 401(k) at work?”
To be clear, both of these are good options. And if you aren’t taking full advantage of any employer-matching contributions, you should almost certainly boost your 401(k) contributions before putting money into an IRA.
Having said that, one of the key advantages of IRA investing is that you’ll have a much wider range of investments to choose from. 401(k) plans, at best, typically offer a couple dozen investment funds you can choose from. On the other hand, you can invest your IRA funds in virtually any stock, bond, or mutual fund you can think of. If you want to put some of your retirement savings in Berkshire Hathaway stock, for example, an IRA can allow you to do just that.
Tax-deferred investment profits
In addition to the tax deduction you could get with a traditional IRA or the tax-free retirement income of a Roth IRA, your IRA investments are also free to grow and compound on a tax-deferred basis.
This means that if you sell a stock or another investment in your IRA at a profit, you won’t pay a dime in capital gains taxes on the sale. And if you receive a dividend from an IRA investment, you won’t pay any income taxes on the dividend (provided you don’t withdraw it from the IRA).
With a Roth IRA, you won’t pay any taxes at all, regardless of your dividends and investment profits. And with a traditional IRA you won’t pay any taxes until you withdraw money from the account, at which point your withdrawal will be considered taxable income.
Perhaps the best reason to open an IRA is to improve your financial security in retirement.
Many Americans don’t realize it, but Social Security is only designed to replace about 40% of the average worker’s income. Meanwhile, most financial planners (myself included) estimate that most people will need a retirement nest egg that generates between 70% and 90% of their pre-retirement income in order to maintain the same standard of living.
Unless you are expecting a pension from your employer, which is getting increasingly rare, the difference will need to come from your retirement savings.
A little now can go a long way later
Here’s the best reason to open an IRA now. The longer you allow your investments to remain in your IRA, the more powerful the concept of tax-deferred compounding is. In other words, a relatively small amount of money can become a large amount of money over time, especially when you don’t have to worry about paying tax on your dividends or capital gains each year.
Consider this example. Let’s say that you contribute $5,000 to an IRA this year and invest the money in a simple S&P 500 index fund (which by the way, is Warren Buffett’s favorite investment for most Americans). While the S&P 500 can be quite volatile from year to year, over long periods of time the index has generated 9%-10% annualized returns.
Based on the low end of this historical range, this means that a $5,000 investment could grow to more than $28,000 after 20 years. After 30 years, you’d have more than $66,000 based on a 9% return. And if you leave it invested for 40 years, you’d have over $157,000.
And this is just based on one $5,000 investment. Imagine if you make a similar contribution to your IRA every year.
Not an exhaustive list
There are dozens of good reasons to open an IRA, so this is by no means an exhaustive list. The key takeaway is that an IRA has tremendous tax benefits and can help you achieve financial security in retirement faster than you’d be able to with a traditional brokerage. And your money will never have as much of a time advantage as it does right now, so there’s no better time to open an IRA and put your money to work in it.
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