Congress introduced individual retirement accounts (IRAs) for Americans in 1982 as a means of saving money for retirement on a tax-deferred basis. And while virtually every financial expert, author and professional will tell you that you need to have one of these accounts at some point, it is important to know the rules that govern these accounts. Those who do not know how these accounts can work could end up making serious and costly mistakes. Here is a list of some of the things that you can do with your IRA.
TUTORIAL: Retirement Planning
Taking an Early Distribution
Your IRA is the last place that you should take money from if you need it, especially if you are just using it to pay current expenses. Any distribution that you take from your IRA before the age of 59, half is not only fully taxable as ordinary income, it is also subject to an additional 10% early withdrawal penalty. Therefore, a $10,000 distribution could be reduced by $4,000 after tax and penalty, depending upon your tax bracket. There is a list of qualified exceptions to the penalty, such as a withdrawal for higher education expenses or to purchase your first home, but think carefully before you do this and figure out how much you would have at retirement if you were to leave the money there. If you need cash now that you know you can repay within a relatively short time, then it might be wiser to take a loan from your company 401(k) plan if you have the option.
Paying Too Much In Fees
Fees and administrative charges can materially reduce the rate of return that you earn on your investments inside your IRA. Some IRAs charge substantially higher administrative fees than others. An IRA offered by one custodian may cost $100 per year to maintain while an institution across the street offers no-fee IRAs.
Being Overly Conservative
Not taking enough risk in your IRA can be just as destructive as taking too much. CDs and other guaranteed instruments will never outpace inflation in terms of growth. If you want to increase your purchasing power over time, then you will need to invest at least a portion of your portfolio in equities such as stocks, mutual funds or REITs. (For more on developing your portfolio, read Achieving Optimal Asset Allocation.)
Forgetting to Diversify Your Portfolio
You can dramatically lower the amount of risk that you take in your IRA if you diversify your portfolio adequately between stocks, bonds and cash. If you have all of your money in a single stock, fund or other instrument, then you are probably taking an unnecessary risk of some sort. Of course, you need to weigh the allocation in your IRA against all of your other retirement and non-retirement savings in order to accurately gauge this. For example, you may want to focus on safe investments in your IRA if your retirement plan at work is invested primarily in company stock.
Failure to Roll Your Company Plan into an IRA
One of the costliest mistakes that you can make when it comes to IRAs is not using one to rollover your company retirement plan into when you leave or retire. Those who ask to have a check sent to them for their plan balance will automatically have 20% of their plan withheld, per IRS regulations. The easy way to avoid this penalty is to simply roll the plan over into an IRA.
The Bottom Line
These are just some of the mistakes that IRA owners can make. For more information on IRAs, download Pub. 590 from the IRS website at http://www.irs.gov/ or consult your financial advisor.