There are many different investment choices that you can incorporate into your retirement strategy. You may choose to invest your money in a tax-advantaged retirement savings vehicle, such as an individual retirement account, or IRA, or you may prefer selecting individual investments, such as index funds, which are more flexible and may be suited to your particular situation. However you choose to invest your money, it's important to understand the pros and cons of each beforehand.
Definition
An IRA is a special type of account regulated by the Internal Revenue Service that allows you to save money over the long term for retirement purposes while potentially enjoying certain tax advantages. The Securities and Exchange Commission defines an index fund as a mutual fund or unit investment trust that is designed to achieve approximately the same return as a particular stock market index, for example, the S&P 500.
Types
The IRS identifies two main types of IRA--the traditional IRA and the Roth IRA--although certain employers may also be eligible to invest in a SIMPLE, or Savings Incentive Match Plan for Employees, IRA. You can also save for college expenses with an education IRA, more commonly known as a Coverdell Education Savings Account. Index funds may be categorized according to the particular index they follow or their asset class. For example, an index fund may track the Nasdaq Composite or the Russell 2000 and then be classified as a growth and value fund or equity and fixed income.
Features
IRAs feature a maximum annual contribution limit, income limits on who can contribute, guidelines for qualified withdrawals and penalties for early withdrawals outside the IRS guidelines. IRAs offer a wide variety of investment choices, including index and other mutual funds as well as individual stocks and bonds. Index funds are typically composed of the securities--that is, stocks and bonds--held by a group of companies that are included in a specific index.
Benefits
The primary benefit of an IRA is the tax benefits they can potentially offer. For example, you may be able to deduct your contributions to a traditional IRA or if you have a Roth IRA, enjoy tax-free growth and withdrawals of your contributions. Index funds can benefit investors who seek a broader, more passive investment strategy, and they also typically have lower management fees than other types of mutual funds.
Considerations
When choosing an IRA, you should evaluate your personal financial situation to determine which type of account will offer you the most tax advantages. You should also be aware of the circumstances under which you're allowed to make withdrawals and the penalties associated with taking distributions prior to reaching retirement age. If you're planning to invest in a particular index fund, you should look at the overall performance history of the fund as well as the index it tracks and also be clear about any fees associated with the fund's management.
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