For an amount of money like $5,500 a year ($6,500 for those over age 50), all of us have an awful lot riding on an IRA. According to the Investment Company Institute, Americans had over $24.6 trillion dollars socked away in total retirement assets with $7.5 trillion in IRA accounts as of the second quarter of 2016. That makes IRAs the biggest place that people have parked their money for retirement in the country. In addition to direct contributions, a lot of that money has come from rollovers of retirement assets from previous employers’ accounts.
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. But, there are a lot of things that can go wrong when and if you stub your toe in the IRA process. It can wind up costing you a lot of money, and that is the money that you are counting on for your retirement and that can screw up your “golden years” if you’re not careful.
IRAs give you great retirement opportunities, but the rules of the game can also be quite bizarre, complicated, and confusing.
There are Roth and Traditional accounts to choose from, and then there’s the IRS tax code that defines the transfer of money in and out of the accounts. The rules that cover the withdrawals, RMDs (required minimum distributions), and conversions are constantly being revised and changed during your IRA lifetime. After 45 years of working (some of that in the financial world), I have come across many questions and misunderstandings that can lead to some problems with investments and your retirement plans. To avoid mistakes, check out this list of things you need to know so you don’t have to say, “I woulda, coulda, shoulda” when you do retire!
10 IRA Mistakes That Can Screw Up Your Retirement Plan
1. You keep waiting until the deadline to contribute each year
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. When you don’t have your full contribution in the account from the beginning of the tax year, you are hurting your IRA. 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. You assumed a Roth IRA is always better than a Traditional IRA
You probably heard so many of the virtues of the Roth IRA accounts like its tax free compounding and withdrawals and no RMD in retirement that you have 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.
Don’t just think of your annual contribution as an either/or decision. Your Roth or Traditional decision is based on you tax rate today versus where it will be in retirement. 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 401k plan at work if they give you that option.
3. You can’t make a Roth IRA or Traditional IRA deductible contribution because of your income level and don’t know what to do
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 main benefit of doing the non-deductible route is your ability to convert you 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). Currently these are still allowed, but President Obama has put forth a plan that will close this loophole if adopted in the next budget. For now though, it’s a perfectly legit option around the IRS rules.
4. You assumed your converted “backdoor” Roth IRA is always 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. You stopped contributing to your IRA as you got older
While it is true that you can’t make Traditional IRA contributions after you reach age 70½, 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 income. When filing jointly, you and your spouse can combine your earned incomes (even if only one of you works). This works best for those who don’t expect to use all of their retirement funds in their own lifetime and the money then can be left to their heirs and taken by them tax free when inherited and withdrawn.
6. You didn’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 you 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. The actual money can come from you. After all, your teen needs his Starbucks coffees and his movie tickets from his actual earnings, doesn’t he?
7. You forgot 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. Don’t miss this opportunity to maximize the earning and tax advantages of a spousal account even for a non-working spouse.
8. You delayed your contributions because you need money right now
A lot of investors, particularly younger ones, 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.
9. You didn’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 you may have to wait even longer so check with a financial advisor on the requirements.
10. You thought of your 401k plan as “mad money”
When you have amassed funds from you 401K 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 whether you have opened your IRA outside of employment or not. I can’t tell you how many people cash out their 401k’s when they change jobs and blow it on something they want on a whim. Don’t ever think to do that. That money will pay for your retirement.
IRA accounts are the core of anyone’s retirement planning. There are many huge pluses in having that money, but there are also many potential mistakes you can make along the way. Educate yourself to insure a comfortable retirement. These 10 are just the tip of the iceberg…but the rest is for another day and another post.
Do you contribute to an IRA every year? Do you understand all of your choices and feel confident about your decisions? Have you ever sought out professional advice about retirement planning and the course you should be taking?