The most common e-mail I get goes something like this:

I’m going to start a Roth IRA on my own, and I’d like to know what online sites you or your readers would suggest. I want to invest in index funds, having heard they are the bee’s knees, but books and the web, and magazine articles are sadly silent on the HOW, spending lots of time on the WHY.

Right now I’m looking heavily at e*trade and ING. I need to know more about Roths before I make my final decision, although ING is looking the best right now. Vanguard sounds good, but that $3000 minimum is a problem.

This is a big question, and I have a lot of information to share with you, so I’ve divided my response into three parts. Today I’ll provide a brief overview of IRAs. In part two, I’ll explore at how and where to set up an IRA. In the final part, we’ll discuss various investment options.

IRAs are easy — there’s no reason to be frightened of them. Don’t let anything that follows intimidate you. (If you have questions, please ask in the comments.)

If you don’t understand why it’s important for you to open a Roth IRA, please watch this video about the power of compound returns. Then read about how compound returns favor the young. The earlier you begin to save for retirement, the easier it is, and the wealthier you will become.

Individual Retirement Accounts
An IRA is an Individual Retirement Arrangement, though it’s more commonly called an Individual Retirement Account. An IRA is simply a holding account. It’s a label. When you open an IRA, it contains nothing. Like a bucket, it’s a place for you to put things.

The things you place in your bucket are investments. You might, for example, buy stock through your retirement account. Or maybe government bonds. Some people use their IRAs to buy real estate. And some simply let their cash sit there, earning interest, just as it would if it were deposited in the bank down the street. (Last night I spoke with a friend who had his IRA funds sitting in a savings account, and only yesterday moved the money to an index fund!)

Smart people mix things up over time. Their buckets may contain a combination of stocks, mutual funds, bonds, and real estate. But they don’t have to. Your IRA can contain a single index fund, if that’s what you want.

An IRA is not an investment — it’s a place to put investments.

Types of IRAs
When you use a non-retirement account, you invest post-tax money. Depending on how you invest, you may also be taxed on dividends and capital gains along the way. You’ll also be taxed on the earnings when you sell your investment. An IRA avoids one set of taxes, allowing your money to compound more quickly. The two types of IRAs that you should know about are “traditional” IRAs and Roth IRAs.

With a traditional IRA, the money you invest is probably tax deductible, but the money you pull out at retirement will be taxed at the then-current rate. You don’t get a tax deduction on the money you contribute to a Roth IRA, but at retirement, earnings can be withdrawn tax-free. Put another way: money in a Roth IRA is taxed at the front end, money in a traditional IRA is taxed at the back end.

Unless you earn a lot of money, a Roth IRA is probably ideal for most people reading this site. The rest of this article deals specifically with Roths.

Roth IRA Rules and Requirements
Not everyone qualifies to contribute to a Roth IRA. If your tax filing status is single and you earn more than $95,000, your contributions are restricted. If you are married filing jointly, your contributions are limited if your household income is more than $150,000. Moneychimp explains:

IRAs were created to encourage people to save for their retirement, by offering them a significant tax break. They are intended for ordinary working people — not, for example, the wealthy (income limits prevent them from participating), or trust fund kids too lazy to get a job (contributions have to be made from salary, not from investments or other income).

Check out Moneychimp’s Roth IRA contribution limit calculator to see if you qualify. (The calculator is a little buggy — be sure to start at the top and re-select all parameters if you make any changes.)

Other important facts:

  • If you are not yet 50 years old, you may only contribute $4,000 to your IRA in 2007 — if you’re older, you may contribute $5,000. (If you go over limit, you are fined on the excess amount. I’m unclear as to whether the rest of the excess can then remain in the account.)
  • To invest in a Roth IRA in any given year, you (or your spouse) must have earned income. (In other words, you can’t contribute to a Roth if all of your money came from an inheritance during a particular year.)
  • You can use a Roth IRA even if you have a 401k or other retirement plan.
  • You must make your contributions by the tax deadline each year.
  • Reinvestment of dividends and distributions are not counted against your contribution limit.
  • You can invest in almost anything you want. (Some things — such as life insurance or collectibles — are off-limits.)
  • You may withdraw your contributions at any time without penalty. If you attempt to withdraw your earnings before the age of 59-1/2, they will be subject to taxes and a 10% early withdrawal penalty (except in special circumstances).
  • Also — and this is a big one for many people — you may withdraw up to $10,000 in earnings without penalty in order to buy your first home.

There are other arcane guidelines and provisions, but these are the basics.

Where to open an IRA
There are many places to open retirement accounts. Each has advantages and disadvantages.

Many banks and credit unions offer IRAs, but they may only allow the money to be used for certificates of deposit or money market accounts. Big-name mutual fund companies like Vanguard are great places to open an IRA, but they often require a minimum initial investment of several thousand dollars and provide a limited universe of investment choices. Discount brokerages like Sharebuilder and E*trade allow new investors to begin saving for retirement with no minimums, but their fees may be higher.

There’s no one right place to open an account. You will need to search for a place that is good for you. (I’ll explore some options in part two of this series.) Questions to ask during your research include:

  • Is there a minimum initial investment?
  • What sorts of fees are assessed to the account?
  • Does the company offer automatic contributions? What are the limits?
  • What investment options are available? Can you invest in stocks? Mutual funds? Real estate?
  • Is it possible to download statements automatically into Quicken?

Remember: the perfect is the enemy of the good. It’s far better to open a Roth IRA now through any provider than it is to delay because you’re worried about finding the number-one best place. Do some research. When you find a place that meets your requirements, open an IRA. Don’t fuss and fret, worrying whether or not it’s the best choice. Find a good choice and go with it.

IRAs are easy. They’re just tax-advantaged holding accounts for your investments. Don’t be frightened of them. For more information check out:

In the next part of this introduction to Roth IRAs, we’ll explore what it’s like to actually open an account. Preview: it’s pretty darn easy.

Remember: I’m just learning about IRAs myself. I’m sure to have missed some things. Fortunately, there are some sharp Get Rich Slowly readers out there to clear up mistakes. (I’ll incorporate corrections into the body of the post.)

Addendum: Matt_In_TX has an excellent point. “Please study IRA and taxes for yourself, and also seek professional advice when needed. Not all the information here is necessarily complete or correct for your situation. ” I’ve done my best to be accurate, but this is only an overview. It’s important to do your own research. I am not a financial professional — I’m just a guy like you trying to learn more about money.

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