One of the surest ways to bolster your nest egg is to take advantage of special tax breaks offered by the IRS. That basic precept explains the popularity of individual retirement accounts (IRAs), one of the cornerstones of retirement planning in the U.S.
- IRAs have annual contribution limits which collectively apply to all deposits made to either a traditional IRA, a Roth IRA, or both.
- IRA contribution limits are raised every few years to keep up with inflation: In 2019, individuals can set aside up to $6,000 per year; those 50 and older can save an additional $1,000.
- Roth IRA contributions are also affected by an individual's overall income.
- Traditional IRA contributions are also affected by participation in an employer-sponsored retirement plan.
- You can contribute to IRAs on a variety of schedules; dollar-cost averaging can be an effective, economical way to invest funds.
How Traditional IRAs Work
Like employer-sponsored 401(k)s, traditional IRAs can dramatically reduce the amount of income you have to fork over to the federal government. Investors generally contribute pretax dollars and the balance grows on a tax-deferred basis until retirement. Withdrawals after the age of 59½ are then subject to ordinary income taxes, at the rates of your current tax bracket.
Be aware, though, that there are limits on how much you can contribute. It’s also worth bearing in mind that the two most common varieties of this savings vehicle—traditional IRAs and Roth IRAs—have different rules.
IRA Contribution Limits
For 2019, the standard contribution limit for both traditional and Roth IRAs is $6,000. If you’re 50 years of age or older, the IRS provides a “catch up” feature that allows you to contribute an extra $1,000 each year for a total of $7,000.
If you’re rolling over another retirement plan into an IRA, annual contribution caps don’t apply.
That may not sound like a lot of money, but it’s enough to have a big impact on your account performance over a long period of time. As an example, let’s take a 30-year-old who contributes the full $6,000 every year until retirement. Assuming a 7% annual return, the account will have a balance of $$887,481 when the investor reaches age 65, not including catch-up contributions. After taxes—assuming a 22% tax rate in retirement —it’s still worth $$692, 235. And remember, the contribution limit is also increased over time by the IRS to keep up with inflation.
The chart below shows how the tax advantages of an IRA can have a dramatic impact on savings over the course of several decades.
Let’s say that the retirement saver's effective tax rate right now, while they're earning steady income, is 24%. Had they put the same portion of each paycheck in a taxable savings account, it would be worth far less. Why? Because the IRA's tax deduction gives retirement savers greater purchasing power.
Suppose, after paying taxes, that our 30-year-old could only afford to put $4,560 into a standard savings account. If the money was put into an IRA instead, it would reduce the tax bill, allowing the account holder to put in an additional 24%, or $1,440. Over time, that drastically increases the size of the nest egg.
How Employer-Sponsored Plans Affect IRAs
While anyone can contribute up to $6,000 (or $7,000 for individuals age 50 and older) to a traditional IRA, not everyone can deduct that full amount on their tax return. If you or your spouse (if you are married) participates in a retirement plan at work, you’re subject to certain income-based restrictions based on your modified adjusted gross income (MAGI).
If you’re single and make more than $64,000 and less than $74,000 a year, for example, you’re only allowed a partial deduction on IRA contributions. Single filers who make $74,000 or more can’t deduct any of their contributions.
Common types of employer retirement plans include:
Different Rules for Roth IRAs
Up to now, we've discussed traditional or standard IRAs. When setting up an IRA, most investors have two choices: the original version of these savings accounts, which date back to the 1970s, and the Roth variety, introduced in the 1990s. In some respects, the tax treatment of the Roth IRA is just the opposite of its older cousin. Instead of getting a tax deduction on contributions upfront, account holders kick in post-tax money that they can withdraw tax-free in retirement.
The Roth version of the IRA has the same contribution limits as a standard IRA. But unlike traditional accounts, the government places restrictions on who can contribute. To determine your eligibility, the IRS also uses MAGI as a metric. Basically, it’s your total income minus certain expenses.
Most taxpayers qualify for the full contribution allowance, although certain higher-earning individuals are only permitted a reduced amount. In 2019, single filers with a MAGI of more than $137,000 per year and joint filers who bring in more than $203,000 are disqualified from Roth IRA contributions altogether.
There’s another area in which Roth IRAs differ from traditional IRAs. With the latter, you can’t make contributions past the age of 70½ and you have to start taking required minimum distributions (RMDs) from your account at that age. Neither is true with the Roth version, which has no age restriction for contributions and no RMDs.
How to Contribute to IRAs
You can contribute to either type of IRA as early as Jan. 1—or as late as the tax year’s filing deadline in mid-April each year. It’s up to you whether you make one large contribution or make periodic contributions throughout the year. Those could be daily, biweekly, monthly, quarterly, or in a single lump sum each year.
If you have the money, it can make financial sense to make the full contribution at the beginning of the year. That gives your money the most time to grow. For many people, however, it’s difficult to come up with $6,000 all at once. In that case, it’s better to set up a contribution schedule.
It’s usually easy to set up automated payments that transfer money from your bank account into your IRA account on a regular schedule. That could be every two weeks (when you get your paychecks) or once a month. Setting up periodic contributions makes that $6,000 more manageable, and it has another benefit, too: dollar-cost averaging.
Dollar-Cost Averaging for IRAs
Dollar-cost averaging (or systematic investing) is the process of spreading out your investment over a specific time period (a year, for our purposes). It’s a disciplined approach that’s tailored-made for IRA contributions.
With dollar-cost averaging, you invest a certain amount of money into your IRA on a regular schedule. The key thing is you invest that money, generally into either a mutual fund or a stock, regardless of what the investment’s share price is. In some months, you’ll end up buying fewer shares per dollar investment when the share price rises.
But in other months, you’ll get more shares for the same amount of money when prices fall. This tends to level out the cost of your investments. You end up investing in assets at their average price over the year (hence the name, dollar-cost averaging).
Spreading out when you invest is a good idea, especially if you’re risk-averse. It effectively reduces the average cost basis of your investment—and hence, your breakeven point, an approach known as averaging down.
Here’s an example. Let’s say you have $500 to invest in a mutual fund every month. In the first month, the price is $50 per share, so you end up with 10 shares. The next month, the fund’s price falls to $25 per share, so your $500 buys 20 shares. After two months, you would have bought 30 shares at an average cost of $33.33.
Using dollar-cost averaging, you only need to commit $500 per month in order to reach the annual limit, or $250 every two weeks, if you invest on a paycheck-to-paycheck basis.
How Much Should You Contribute to an IRA?
That's a good question. It's tempting to say you should fund it to the allowable max each year—or at least up to the deductible amount if you're going with the traditional type.
Lovely as it would be to furnish a hard-and-fast figure, though, a real-life answer is more complicated. Much depends on your income, needs, expenses, and obligations. Laudable as long-term saving is, most financial advisors recommend you clear your debts first, if possible—unless you're mainly holding "good" debt, like a mortgage that is building equity in your home. But if you have something like a bunch of outstanding credit card balances, make settling them your first priority.
The average annual IRA contribution, according to the Employee Benefit Research Institute.
Much also depends on how much money you think you'll need/want in retirement, and how long you have before you get there. A variety of ways exist to figure out this golden sum, of course. But it might make more sense to come up with an ideal number, and then work backward to calculate how much you should contribute towards your accounts, figuring average rates of return, the investment time frame, and your capacity for risk—rather than just blindly committing a certain sum to an IRA.
Figure in what other sorts of retirement-savings vehicles are open to you, too—such as an employer-sponsored plan like a 401(k) or 403(b). Often, it's more advantageous to fund these first up to the allowed amount—a 401(k) has higher contribution limits than an IRA—especially if your company generously matches employee contributions. After you've maximized the subsidy, you could then deposit additional sums into a Roth IRA or a traditional IRA (even though the contributions may be nondeductible).
However, if your workplace plan is unsatisfactory (little or no match, highly limited, or poor investment options), then make your IRA the primary nest for your retirement funds. It’s easy to open an account at a brokerage firm, mutual fund company, or bank, for instance. In addition to mutual funds and exchange-traded funds (ETFs), many IRAs allow you to pick individual stocks, bonds, and other investments as well.