IRAs are the biggest places that people park their money for retirement in the country. In addition to direct contributions, a lot more money also comes from retirement assets from employers’ 401(k) accounts. According to the Investment Company Institute, Americans have over $35 trillion dollars socked away in total retirement assets right now. But here’s my warning: Don’t screw up your retirement plan with these IRA mistakes!
How Can Something So Simple Be So Dangerous?
Opening an IRA account seems like it’s a fairly simple thing. You go to a bank or you can pick a brokerage firm or a mutual fund company (even online), fill out a few forms, and then move some money into the account.
At work, once you are eligible, you can contribute money from your pay into a retirement account and even get some matching free money when you do. That is a great deal.
But there are a lot of things that can go wrong when and if you stub your toe in the retirement planning process. It can wind up costing you a lot of money, and that is the money that you are counting on for your retirement peace of mind. You should understand the rules of this game so that you don’t get screwed. The rules are sometimes quite bizarre, complicated, and confusing.
10 IRA Mistakes That Can Screw Up Your Retirement Plan
Between Roth and Traditional accounts, 401(k) plans and the IRS tax code that defines the transfer of money in and out of the accounts, confusion reigns.
The rules that cover the withdrawals, RMDs (Required Minimum Distributions), and conversions are constantly being revised and changed. To avoid IRA mistakes, you need to know all of the facts so you don’t have to say, “I woulda, coulda, shoulda” when you do retire!
1. Don’t wait every year until the deadline to contribute
Many investors wait until their tax filing deadline (usually April 15) to invest in their annual IRA and that can be a big, big costly mistake. By waiting, you lose time (up to 15 months) for compounding your money and growth that can really add up over the many years your IRA is invested. If you are unable to invest your total contribution at the beginning of the tax period, one alternative way to offset this is to set up an auto-invest option. You can then contribute a fixed installment monthly until you reach your IRA annual limit.
2. Don’t think a Roth is always better than a Traditional IRA
You probably heard many of the virtues of the Roth IRA accounts—like its tax free compounding and withdrawals and no RMD in retirement—that you assumed that they are always the best choice. They’re not.
If you’re an investor who can deduct the Traditional IRA from their income taxes because you fall under the income limitations and haven’t saved that much for your retirement as of yet, the Traditional IRA may be the better choice. That is because your in-retirement tax rate is apt to be lower than your current tax rate (while working) and that contribution and deduction is worth more to your finances now rather than later.
Even if you have no idea what your tax rate might be in retirement, you can invest half of your contribution in a Roth and half in a Traditional account and reap some benefit either way. You can also use this same strategy for a 401(k) plan at work if they give you that option.
3. Don’t assume you can’t make an IRA contribution because of your income level
You can always make a non-deductible contribution of course and it will still compound and earn monies towards your retirement. But there will be two huge drawbacks. First, there will be an RMD. Second, there will also be the ordinary income tax on your eventual withdrawals. The non-deductible route is your ability to convert your Traditional account to a Roth account by is what is called the “backdoor Roth IRA maneuver”.
To do this, shortly after you open your Traditional account, you can convert and there are no income limits on these procedures (as long as it remains in cash only). For now though, it’s a perfectly legit option around the IRS rules.
4. Don’t assume your converted “backdoor” Roth IRA is tax free
Not necessarily. Your tax-free ride will only hold if the money you used to open the Traditional account remains in cash only before the conversion (where it was exempted from taxes). If it wasn’t, and you have substantial Traditional IRA assets that have never been taxed, you may find that your backdoor account will be partially or even completely subject to income taxes upon withdrawal.
5. Don’t stop contributing to your IRA as you get older
While it is true that you can’t make Traditional IRA contributions after you reach age 72, you can make Roth IRA contributions. There are some rules, like you must have earned income to do it, and your Social Security or your investment monies don’t count as earned income. When filing jointly, you and your spouse can combine your earned incomes (even if only one of you works).
6. You don’t know anything about “gifting” an IRA?
You can actually make contributions to a Roth IRA account for your kids if you want to “kick start” their retirement plan even at a really early age. You are only limited by the child’s earned income as the amount you can use up to $5,500, currently in effect. It doesn’t matter if the child’s earnings aren’t actually the monies used to open the account. You can do it with your own money if you like. What only matters is that the child’s income was either equal to or greater than the amount used to open the account.
7. Don’t forget about your spouse
You would be shocked to learn how many non-earning spouses never have any IRA accounts set up for them. If you earn enough money to fund both your own and your spouse’s accounts, you can do so perfectly legally by setting up two accounts when filing jointly.
8. Don’t delay your retirement contributions because you need money right now
A lot of investors assume that if they ever need their money from a Roth IRA that there will be taxes and stiff penalties involved and their money is essentially locked up until they retire. That’s not true as exceptions are made by the IRS for withdrawals of things like funding college or first time home purchases as examples. It’s never a good idea to raid your IRA account, but it’s a worse idea to not fund it at all just because you may need the money for something else.
9. You don’t know or understand the “5-Year Rule”
It’s pretty straightforward. You can’t withdraw any tax-free funds from a Roth IRA if hasn’t been in the account at least 5 years, even if you are 59½ (the age you can start withdrawing funds tax and penalty free). If you have converted funds from a Traditional to a Roth IRA, you may have to wait even longer, so check with a financial advisor on those requirements.
10. Don’t think of your 401(k) plan as “mad money”
When you have amassed funds from you 401(k) at work, you may think that that money isn’t really your retirement fund until you actually open your IRA account. Wrong. The monies you have invested in your company stock plans offer you a better chance and way of investing for you future, especially when they are supplemented with matching funds, company stock options, and the like. But in every way, your money is still geared for retirement and should never be thought of as extra or mad money. It’s all part of your retirement package.
IRA accounts are the core of everyone’s retirement planning. There are many huge pluses in having that money, but there are also many ways you can screw it all up! These IRA mistakes are just the tip of the iceberg.
Do you understand all of your choices and feel confident about your retirement planning decisions? Are you confident as to the course you are taking right now?