Traditional IRAs can be an excellent way to save for retirement and get a tax break at the same time. You will need to pay taxes on the money eventually when you take it out at retirement, but many people are in a lower tax bracket at that time so taking the tax break earlier can be a benefit (see When Not To Open A Roth IRA).
The tax break also makes it easier to put more money into the IRA. For example, if you deposit the maximum allowed at age 40, which is $5,500 in 2015, and you are in the 25% tax bracket, the tax break can be worth $1,375 ($5,500 x 25%) in reduced taxes. So your out-of-pocket expense for that $5,500 is just $4,125.
In this story we focus on the top ten mistakes you can make with a traditional IRA.
Not everyone can contribute to a traditional IRA. If you are covered by a qualified retirement plan – such as a 401(k) – at work, the tax-deductible amount you can contribute to a traditional IRA may be limited. As long as your income is less than $61,000 as a person who is single or head of household, you can contribute up $5,500 under the age of 50 and $6,500 at age 50 and over. If your income is between $61,000 and $71,000, your allowable contribution is reduced. Earn more than $71,000 and you cannot contribute to the traditional IRA and take a tax deduction.
Married couples with retirement plans at work can still contribute tax-free to a traditional IRA as long as their income is below $98,000. Between $98,000 and $118,000, tax-deductible contributions are reduced. When joint earnings top $118,000, you cannot contribute tax free to a traditional IRA.
If your spouse is covered by a retirement plan at work – but you are not – then you can make a tax-deductible contribution if your joint income is up to $183,000, but less than $193,000.
As discussed above, the maximum amount you can contribute to all your combined IRAs is $5,500 for people under 50. An additional $1,000 in catch-up contributions is allowed for people 50 and older. If you have more than one IRA, such as one traditional IRA and one Roth IRA, be careful to manage your contributions so they do not total more than the allowable limits in any one year.
If you make a mistake, there can be a 6% IRS penalty on the excess amounts for each year that they remain in the IRA. If you realize your mistake, in time (prior to filing your taxes) you can take out the excess amount. Or you can amend your taxes and indicate that the excess will be moved to the next tax year. Just be sure you let the IRS know in writing how you are handling the excess contribution to avoid a penalty.
Generally money deposited in an IRA cannot be taken out before the age of 59½. If you do take money out of a traditional IRA prior to that time you will likely have to pay a 10% penalty, plus pay taxes on the amount withdrawn at your current tax rate. That tax rate can jump significantly if you take a lot of money out. For example suppose you earn $35,000 and are in the 15% tax bracket. You decide to withdraw $10,000. That means your income will now be in the 25% tax bracket. So if you do want to withdraw funds early, always be sure to look at the tax consequences.
You can take out money and avoid the 10% penalty for a number of reasons, such as a hardship withdrawal, medical expenses, qualified education expenses or buying your first home. You will still need to pay taxes on the money withdrawn at your current tax rate. If you do need to take money out before 59½, be sure to contact a tax advisor before taking the withdrawal so you understand the potential tax impact.
If you are age 55 or older and lose your job, there also options you can consider to avoid the 10% penalty for early withdrawal of IRA money.
Once you get to "April 1 of the year following the calendar year in which you reach 70½," according to the IRS, you must start taking money out of your traditional IRA or face stiff penalties. This is known as the required minimum distribution (RMD) and the penalty for ignoring it can be as high as 50% of the amount that should have been withdrawn.
Figuring out your RMD is not hard. The IRS provides tables: Joint and Last Survivor Table (if your sole beneficiary is a spouse more than 10 years younger than you), Uniform Lifetime Table (if your spouse is sole beneficiary and not more than 10 years younger than you), and Single Life Expectancy Table (for beneficiaries of an account). You can find those in IRS Publication 590-B.
You can’t invest in just anything as part of your traditional IRA. Some things are prohibited. These can included buying collectibles, borrowing from it, selling property to it or buying property for personal use. If you engage in any of these activities, the IRA is no longer qualified and the account is treated as a distribution. For more, see Qualifying Assets For Your IRA.
If you or your spouse does not work, you should open a traditional IRA for the non-working spouse. You can fund the Spousal IRA up to the limits allowed based on your spouse’s age, provided that the money you deposit is earned income from salaries, wages or commissions.
You may think you missed out on making a contribution if you didn’t do so by December 31 of the tax year for which you are filing. But that’s not true. You have until April 15 of the next year, the tax-filing deadline, to make your IRA contribution. If tax day falls on the weekend, you have until the following Monday.
While you do have until April 15 of the next year to make a contribution, the earlier in the year you can make that contribution, the better. Your money will have more time to earn money for retirement the earlier you can make the deposit.
You must stop contributing to a traditional IRA after age 70½, even if you are still working. No contributions are allowed in a traditional IRA after age 70½. One reason to be especially careful about this: Any money you did contribute would be considered excess contributions and would be penalized 6% per year for as long as they are in the account.
Beginning in 2015, only one rollover of any type of traditional IRA to another type of traditional IRA is allowed in a 365-day period. There are no limits on certain other types of transactions, however:
– Rollovers from traditional IRAs to Roth IRAs (conversions)
– Trustee-to-trustee transfers to another IRA (not considered a rollover by the IRS)
– IRA-to-plan rollovers
– Plan-to-IRA rollovers
– Plan-to-plan rollovers
The biggest mistake you can make is not paying attention to the assets held within your IRA. It’s a good idea to review your asset allocation once or twice a year (not more frequently because you don’t want to react to short-term market swings). For help with this, see The Best Portfolio Balance.
Remember this is a long-term investment and the market will go up and down. Decide on an allocation that fits your tolerance level for the ups and downs. Generally, advisors today recommend that the growth portion of your portfolio should be 110 or 120 minus your age. So if you are 30, the percentage of your portfolio in growth stocks should be 80% or 90%. Stock portfolios should also be allocated among large cap stocks (big companies), mid cap stocks (mid-size companies) and small cap stocks (small companies). You also should have a good mix of industries in your portfolio. Mutual funds can help you get the proper mix if you have a small portfolio or you don’t have the time to research and pick stocks. (For more, see our tutorial Mutual Fund Basics.)
Be sure to start investing in an IRA early and regularly. It definitely is not something that should be put off until you are nearer to retirement.
Start by deciding whether to open a traditional IRA or a Roth. If you don’t need the tax break – or have a 401(k) – then a Roth IRA may be the better option if you meet the income requirements (see Top 10 Mistakes To Avoid On Your Roth IRA).
Follow the rules of whichever tax-advantaged retirement plan you choose and you can start saving your way toward a financially healthy retirement.