Here is something we hear on occasion at CameronDowning: “I’m not sure an IRA is for me. I hear it may be too risky.” The problem with this statement is that an IRA, or Individual Retirement Account, is not an investment. So what is an IRA?
An IRA is technically a registration
It holds investments, but is not an investment itself. You can put all kinds of investments within an IRA. Consequently, stocks, bonds, mutual funds, CDs, and even gold bullion are investment options within an IRA. You can be 100% in cash in an IRA, which by definition has no risk. We’ve also commonly seen annuities put in IRAs which is typically not a good idea, and I discuss why elsewhere.
So what is an IRA?
Getting the terminology right is important. Picture a candy wrapper holding chocolate inside. An IRA is like the candy wrapper. Likewise, there are different kinds of candy wrappers just like there are various kinds of IRA registrations. Traditional, Roth, SEP, SIMPLE are the most commonly known IRAs. Why is this important? In particular, different IRA registrations have different tax benefits. Sometimes the tax benefits of an IRA are more important than any potential gain from markets. As far as the question of risk in an IRA, it depends on what investments you choose within the registration.
An IRA is not a 401k
I’ve also commonly heard the 401k and IRA used interchangeably. While both 401ks and IRAs are are retirement account registrations, they are different in many ways. A 401k is an employer-based retirement account. You can only open one through your employer, or if you are a business owner. The IRA most similar to the typical 401k is the Traditional IRA. Traditional IRAs may be opened through many banks, an online brokerage, or through your financial adviser. Traditional IRAs and 401ks have different contribution limits, require different attained ages to withdraw funds into a regular checking account without penalty. Also, the 401k is can be costly for small companies to establish since they involve third-party administrators and are governed by stringent, federal laws. An IRA does not require an employer relationship, so anyone can with earned income can open one.
Getting retirement account terms right
Understanding the different between an IRA and an investment is an important first step for long term investing. Before you invest, consider the different registrations available to hold your investments. To learn more about this and other foundational financial planning topics, check out the CameronDowning website. Also connect with us on Facebook, Linkedin, and Twitter.
Jonathan G. Cameron, CFP®
Registered Investment Adviser