I received a phone call earlier this week. Here’s a summary of how the conversation went:
Caller: Do I need a Roth IRA or Traditional IRA?
Me: Roth. Where are you opening it?
Me: Do you know what to invest in?
Me: We’ll worry about that later. Are you there right now?
Me: Open the account, deposit your money and I’ll work on what to invest it in.
To put the call into context, the caller was from a family member, Karen. She’s 19, a college student and has never taken an interest in investing. So when she called while she was physically at the Scottrade office, I couldn’t help but be proud of her. Starting out a retirement account at such a young age is a great idea.
Let’s work through the conversation:
A Roth IRA is appropriate for her because of her age and student status. It’s likely that she is paying the lowest taxes she might ever pay right now. A Roth can be a great choice for many investors, Free Money Finance discussed it in Retirement Smackdown: Which is Better — Traditional IRA or Roth IRA?
I used to recommend Scottrade because they had access to Vanguard mutual funds for free. Since they now charge $17 per trade for the funds (and $7 for stocks and ETFs), I usually like people to open their account directly at Vanguard. To open an account using index funds at Vanguard $3,000 minimum is needed. Because Karen was at the office, I wanted to keep the momentum going. She also was opening the account with less than the $3,000 minimum. She can always transfer the account to Vanguard when she reaches the minimum.
What to invest in: Vanguard offers a set of target retirement funds that are perfect for investors that want to set it and forget it. The funds are invested in low cost index funds that are broken into total stock market, total bond market, and total international market. The funds adjust as the investor gets closer to retirement.
Vanguard Total Stock Market Index Fund
Vanguard European Stock Index Fund
Vanguard Total Bond Market Index Fund
Vanguard Pacific Stock Index Fund
Vanguard Emerging Markets Stock Index Fund
Because she can’t access the 2050 fund just yet, the next best option for Karen will be a total market index fund. Vanguard has two options that contain the total stock market. The ETF (VTI) and the Index fund (VTSMX). Because she opened the account at Scottrade, the lower cost option is the EFT at $7 per trade. You can run a calculator on the Vanguard site to compare the choices with different investment amounts.
My recommendations for Karen:
- Purchase VTI with the money deposited.
- Continue to deposit a set amount monthly, but do not buy additional shares.
- Each time the holding account reaches $350, purchase additional shares of VTI.
- Once the account reaches $3,000, transfer it to Vanguard and purchase the Vanguard Target Retirement 2050.
Drawbacks to this plan:
- The initial investment will not have any bond or international exposure. This is not an ideal asset allocation. However, Karen is young and has a long time until retirement so going without a bond exposure for a relatively short period of time should be OK in the long run. An international option should be added as soon as possible. Holding VTI will match approximately 72% of the 2050 plan.
- The commission will be relatively high (2%) for the ongoing purchases. Normally I am not a fan of high cost investments. However, in this instance I believe it is best for Karen to get started investing in the market rather than wait it out until she has saved up enough money.
Update: Vanguard Admiral Shares Lower Minimum Balance Requirements in October 2010.