Reader Question: Where to Open an IRA?

Last week I received a great question on where to open an IRA from a reader!  I think this is an important question that doesn’t necessarily get the discussion it deserves in comparison with the question of asset allocation or particular investments.  I’m not a financial advisor, though, so please do your own research as well!

Hey Emily,

I’m starting my first “big kid” job at the end of the summer. So this got me thinking about saving for retirement. I haven’t formally started saving for retirement yet, and that’s one of the things i want to do as I transition into my new budget. The school I will be working for will be eligible for 403(b) contributions, but not until after I work there for a year. So I figured, this first year I would start saving in an IRA account to get in the habit of saving for retirement.

My question is – does it matter where I open my IRA account? It seems that several banks (both large and small) offer IRA’s, and I guess I’m just curious about what factors I should consider when picking where to open my IRA.

Thanks for your thoughts!

~ A new PhD

Hi new PhD,

Thanks for your question! I think it’s great that you’re going to start saving for retirement before you’re even eligible for the 403(b) – I’m sure it will help you combat lifestyle inflation! Saving at a good clip from early on is the most impactful factor in building up a great nest egg – the habit of saving is much more important than which institution or exactly which investments you pick. So great job thinking about this early!

I’ll give you some general guidelines and things to think about and then I’ll tell you the conclusion Kyle and I came to on this issue.

It matters a lot what investments you choose for your IRA, and the types of investments available as well as their cost are influenced by the company you buy them through.

Since this wasn’t the subject of your question, I’ll just breeze through the first couple decisions you need to make. 1) What asset allocation do you want? 2) How diversified do you want to be?

A standard asset allocation for a young person saving for retirement (decades away) is that you want to own mostly stocks, perhaps a bit of bonds, and nothing or almost nothing in cash-equivalents. You will also want to be very diversified, so picking a fund (a mutual fund, index fund, or exchange-traded fund) is an easy way to do that even when you don’t have much money to invest.

Many banks offer IRA accounts, but in some cases the only types of investments you may be able to choose are savings accounts, CDs, or money market accounts, so if you want to buy stock funds you won’t be able to consider those particular banks. I would say in general it’s better to invest through a brokerage firm over a bank.

Let’s say that you’ve chosen the asset allocation you want and how diversified you want to be within your various asset classes and you’re ready to choose the institution you want to use. The key factor you need to look at is the expense ratio of the fund(s). (Oh, and you should probably only consider no-load funds.) The expense ratio is a representation of all the costs of the fund. This is a very important consideration because, while you can’t know for sure what return you’ll get with that investment, you do know that the expense ratio will be taken right off the top of your returns. So if you are looking at two funds that you believe should perform similarly, one of which has an expense ratio of 1.5% and the other 0.5%, it’s clear that you should pick the one with the lower expense ratio since you will likely come out with a 1% higher return with that one. (This type of comparison is most valid for passively managed index funds since they are supposed to have the same returns before factoring in the expense ratio. It may not be a useful way to evaluate actively managed funds, but there are good reasons to avoid actively managed funds anyway.)

If you know that you want to buy an index fund following the S&P 500, for example, you can just Google the names of a few brokerage firms with “S&P 500 index fund expense ratio” and you should be able to find them all to directly compare. You have to be a bit careful with this step because brokerage firms often offer two or more versions of the same fund with different minimum investments. The fund classes with higher minimums usually have lower expense ratios, so be sure to pick out the proper expense ratio for the amount of money you’ll have in the account. If you’re trying to buy a very popular fund like one that follows a major index or a target date retirement fund, you can often find articles directly comparing many companies offering that type of fund so most of the legwork is done for you.

But if you don’t know exactly which fund you want to buy from the get-go or you are interested in possibly buying multiple funds or switching from one to another at some point, you probably want to go with the brokerage firm that in general offers the lowest expense ratios. That way even if they don’t offer the rock-bottom expense ratio for the first fund you’re interested in, they will likely be competitive across all the funds you would potentially buy.

The longtime leader in offering the lowest expense ratios in the industry is Vanguard. Again, it may not be the absolute lowest for every fund, but I think it is a great benchmark for comparing similar funds from other firms. Other low-cost brokerage firms to consider are Charles Schwab, Fidelity, T. Rowe Price, and TD Ameritrade.

Here are a few articles on this topic of expense ratios across different brokerage firms:
The Motley Fool
CBS
Oblivious Investor

Kyle and I have our IRAs with Vanguard because of these low expense ratios. I won’t go into which fund we chose because that wasn’t your question, but we were looking at types of funds that were offered by many firms. I first opened my IRA with Fidelity because I didn’t have enough money in my IRA to meet Vanguard’s minimums, but I switched as soon as I could.

You don’t have to make the absolute best decision about which institution to invest through or which fund to choose from the get-go, so please don’t let paralysis of analysis (if that affects you – it does us!) keep you from opening an IRA and starting to save into it. Starting is more important than being perfect from the beginning!

Thanks for sending me your question and please follow up if you have any more!

Emily

Do you have a different answer for this reader?  How did you choose where to open your IRA and did you consider expense ratios?  Have you switched where your IRA is housed or how it is invested since you opened it?  

photo from Free Digital Photos