Individual Retirement Accounts (IRA) 101
Choose a provider
Guides IRA 101
Decide on the best asset allocation for you and pick your investments. If you're not sure how to do either, call in a pro — or consider a robo-advisor.
One of the best things about an IRA — as compared with, say, an employer-sponsored retirement plan like a 401(k) — is the vastly larger selection of investment options available within the account.
In most accounts, you can buy individual stocks. You can trade options. You can sort through a sea of mutual funds to find the lowest-cost choice. Or you can do none of the above and choose a robo-advisor — a computer-powered investment manager — to do all the work for you. (Check out our top picks for robo-advisors.)
That breadth of choice makes the IRA — both the Roth and traditional versions — an attractive option for your retirement savings, especially once you’ve maxed out 401(k) matching dollars. But in some ways, choice also makes things more difficult for the investor, by muddying the waters.
Here’s a step-by-step process for how to choose investments for your IRA.
1. Understand asset allocation
Just the words “asset allocation” sound complicated, but they’re not: This is simply how your money is divided among different types of investments. Big picture, that means stocks, bonds and cash; little picture, it gets into specifics like large-cap stocks versus small-cap stocks, corporate bonds versus municipal bonds, and so on.
If you invest $10,000 in an IRA account and $6,000 of it is in stock funds and $4,000 of it is in bond funds, your asset allocation is 60/40. You’ll get the biggest return over time — and take the greatest amount of risk — with stocks (also known as equities), while bonds and other fixed-income investments help balance out that risk because they’re relatively safe compared with stocks.
2. Decide on an allocation that works for you
This is the trick of it all, and it involves considering a couple of things, including your time horizon — how long the money will be invested — and your ability to tolerate risk. You want to take enough risk that your money will grow, but not so much that you’ll bail out or lose all your hair when the market gets rocky. (If you’re not sure how you’d react to a market drop, take your pulse with a risk tolerance quiz.)
There are rules of thumb to guide you, the most notable being to subtract your age from 100 or, to sway more toward risk, 110. The resulting number is the percentage of your portfolio that should be allocated toward stocks: Under this rule, if you’re 30, you’d direct 70% to 80% that way. You may find you want more or less equity exposure than the rule dictates, so it’s fine to use it as a starting point and then edge the numbers around until they suit your needs.
You want to take enough risk that your money will grow, but not so much that you’ll bail out or lose all your hair when the market gets rocky.
Your age matters because in general, you want to take more risk when you’re young and then taper down as you inch toward retirement. That doesn’t mean you shouldn’t invest in stocks in retirement — given today’s life spans, you’ll still need that money to last 30 or more years past age 65, and that requires investment growth — but many people choose to dial it back a bit so there’s a greater fixed-income allocation from which to take distributions. That way, if the market takes a dive, you don’t have to sell at a low; you can simply pull from the safer havens in your portfolio.
3. Select your IRA investments
Many people invest through mutual funds and — even better — index funds or exchange-traded funds, which are a low-cost way to track certain indexes, like the Standard & Poor’s 500 index. Through a fund, you’re buying a basket of investments rather than the stock of just one company: An S&P 500 index fund, for instance, invests in 500 of the largest U.S. companies; it’s classified as a “large cap” fund for that reason (“cap” refers to the valuation of the companies).
In most cases, you’ll want to allocate more of the equity portion of your portfolio to the biggest asset classes — for example, that large-cap fund or a total stock market fund and, secondarily, a developed markets or international stock fund — and less to smaller classes, like small- and mid-cap funds and emerging markets. You might put most of your bond allocation into a total U.S. bond market fund, and a lesser amount into an international bond fund.
Choose index funds and ETFs to meet your asset allocation, with the help of a fund screener. This is a tool offered by many online brokers (as well as sites like Yahoo and Morningstar) that can help you sort by expense ratio, fund type, performance and other factors.
Building a portfolio of individual stocks and bonds is everything but a full-time job, requiring extensive research, planning and attention to your portfolio. If you’re willing and able to put in the time, it may pay off.
Of course, if you’re a real go-getter, you can forget funds and build a portfolio of individual stocks and bonds. This is everything but a full-time job, requiring extensive research, planning and attention to your portfolio, but if you’re willing and able to put in the time, it may pay off. (If you’re unsure, allocate a small percentage of your portfolio to stock trading to test the waters; here are our tips for trading stocks.)
4. Know when to leave it to the pros
If you don’t have any interest in selecting funds — much less individual stocks — you might be a good candidate to outsource. There are two ways to get what amounts to low-cost portfolio management: target-date funds and robo-advisors.
A target-date fund is designed to work toward the year its investors plan to retire; because of that, the funds are named by year: If you’re 30, you’d select a target-date fund with 2050 in its title. It will then do all of the work for you, rebalancing as needed and taking an appropriate amount of risk as you age. These funds are very popular in 401(k)s and tend to have high expense ratios, but through an IRA you can shop a wider selection to find a low-cost option. You don’t need to diversify among target-date funds — you put all of your IRA money into the single fund.
To use a robo-advisor, you would need to open an IRA account at one of these companies, like Betterment or Wealthfront. The company would then build and manage an ETF portfolio for you, based on your age, risk tolerance and other factors — most services have you fill out an initial questionnaire — for a management fee of around 0.25%.
No matter what you do, take steps to minimize fees — both investment fees, like expense ratios and commissions, and account fees. Left unchecked, these expenses can quickly start to swallow your portfolio’s returns.