A friend of mine recently asked me about how to get started with opening an IRA since his employer doesn’t offer a 401k. The tricky part of his situation, though, is that he is making minimum wage and said he can only set aside $500 a year. First, I’d like to applaud his efforts to start contributing for his future retirement needs, especially with such limited financial resources.
As I mentioned in a previous post, most investment companies (Vanguard, Fidelity, etc.) require minimum investments of between $1,000 and $3,000 to open an account. He mentioned the idea of opening a ShareBuilder account online at ING Direct, since they have no minimum investment amount. However, the downside is they charge a $4 fee every time you make your monthly contribution. So, if my friend contributes $41.66 a month (to add up to $500 a year), then it will cost $48 in fees (just under 10% of his entire yearly contribution).
We came up with a workable alternative. Most banks and credit unions offer what are called IRA CD’s. These are normal IRA’s that are simply invested in certificates of deposit instead of stocks and bonds. The advantage is that you can typically open one of these accounts with as little as $250. Granted, the interest rates on the certificates of deposit are not very high, but there are no fees involved either.
So, the plan we came up with is for him to transfer the $41.66 every month into a savings account. In December (once the account has grown to $500), he will open a Roth IRA CD at his local credit union. The goal is to do this every year until he has enough funds in the IRA to meet the minimum investment at a traditional investment company (say $3,000). At $500 a year, this will take roughly 6 years at his current contribution level. So, this December he will invest $500 in a 5-year CD. The next year he will invest an additional $500 in a 4-year CD. The next year he will invest another $500 in a 3-year CD, and so on. By the end of that sixth year, he will have more than $3,000 and can then move his IRA to a traditional investment company and invest in stocks and bonds for the higher investment returns. An additional point is to structure the CD maturities to coincide with the timeframe you will want to move your money. For example, each of his IRA CD’s will mature at the same time (the end of year 6), so he doesn’t have to worry about paying any early withdrawal penalties on the CD’s.
One additional benefit I mentioned to my friend is that there is a tax credit for retirement contributions, commonly referred to as the “Savers Credit”. Depending on your income level, filing status, and retirement contributions, you can receive a tax credit of up to 50% of retirement contributions up to $2,000. In my friend’s situation he can receive a $250 tax credit from his $500 IRA contribution, which is a great benefit. Now I’m not a tax professional, and your individual tax situation may be different than his, so consult with your tax preparer to make sure you’re eligible.