An Individual Retirement Account (IRA) can be a potent tool for retirement savings. Annual contributions to your IRA (currently up to $5,500, or $6,500 for those age 50 and over) are often tax deductible. If you have a traditional IRA, the investments grow tax-deferred and are only taxed when they are withdrawn from the account, with mandatory withdrawal beginning at age 70½. IRA income is taxed as regular income, so there’s an added benefit for retirees in a lower tax bracket than when they were working. Traditional IRAs are available to any income-earning individual, although there are income limits to the deduction for people who participate, or whose spouse participates, in an employer-sponsored retirement benefit.
Even so, savvy investors can wring even better returns out of an IRA account. Here’s how:
Compounding money is a snowball effect. Investments and returns are reinvested and generate more returns, which are reinvested, and so on. The longer your money has to compound tax-free, the better off you are. And don’t be paralyzed if you can’t contribute the maximum amount. “Instead of worrying about how much you can put in, just start putting it in,” says Shashin Shah, a financial planner in Dallas. “Even if it’s $25 so that you get into the habit. Then move on to $50, then $100.”
Don’t Wait Until Tax Day
Many people contribute to their IRA when they file their taxes, typically on April 15 of the following year. When you wait, not only do you deny your contribution the chance to grow for as much as 15 months, you risk making the entire investment at a high point in the market. Making your contribution at the start of the tax year at least allows it to compound for longer, though for stocks, in particular, the risk of buying at a peak remains. Instead, Shah recommends making equal monthly contributions throughout the tax year, what's known as dollar-cost averaging. "With dollar cost averaging, you’re buying a little bit each month over that 12-month period. So if the market’s up, you may be buying, and if the market’s down, you may be buying,” he says. “It takes the guesswork out of timing the market.” Moreover, regular contributions instill discipline in investing. “One of the big secrets for investing long-term at any level is having the consistency,” he says.
Use Your IRA to Specialize
For people with a single retirement account, what goes in depends on your investment goals. (Among equities, most advisers recommend index or exchange-traded funds with very low expenses and other fees.) But for more sophisticated retirement planning, financial advisers increasingly recommend distributing retirement investments across accounts based on how they'll be taxed, a theory known as asset location. Traditionally, that's meant that income-earning bonds, which are relatively tax inefficient, belong in IRAs, while stocks and other assets that generate capital gains, which get a tax preference over income, should be held in taxable accounts.
But in practice, according to financial advisor Michael Kitces, not all stock strategies are tax-efficient. Moreover, he adds, where you stash an asset depends not just on tax efficiency but also on anticipated returns and your own situation – high-return but inefficient assets, like an actively managed mutual fund, favor an IRA, while index funds, say, might be better in a taxable account. And it turns out it doesn't matter where lower-return assets, as many bonds, go. In any event, this type of asset division should not warp an overall asset allocation strategy.
On the other hand, if you have an employer-sponsored plan in your retirement portfolio – with all the requisite blue-chip options – you might use your IRA to be more adventurous. Take the opportunity to invest in small-cap stocks, foreign equities, real estate or the many other specialized funds that are now emerging.
Convert It to a Roth
Unlike a traditional IRA, a Roth IRA account is funded with money that has been taxed up front – but once funded, the account can grow and eventually be liquidated free of further tax. As with a traditional IRA, the maximum contribution to a Roth account is currently $5,500 ($6,500 for people age 50 and over), but there are also income limits that make it harder – though, as we'll see, not impossible – for high-earning individuals to have a Roth account. According to Kitces, a Roth account usually, though not always, makes more sense than a traditional IRA if you’re likely to be in a higher tax bracket in retirement. Shah says a Roth is best suited for assets, especially high-growth assets, that can be held for a long time – 30 years or more.
Since 2010, there are no limits on how much money can be converted in a year from a traditional IRA to a Roth account, and there are no income eligibility limits for a Roth conversion, either. In effect, these rules open a back channel to allow people who make too much money to contribute to a Roth account to fund one by converting a traditional IRA.
To the extent that you funded your traditional account with deductible, pretax money, you’ll have to pay taxes on that money when you convert it to a Roth. Many advisors recommend tailoring your conversion to your income and your tax bracket so you don’t find yourself bumped up to the next bracket, even though the added tax expense is small.
For example, if you’re single and your taxable income in 2018 is $75,000, you’re safely in the 25% tax bracket – and you can convert (and pay tax on) $15,750 from a traditional IRA and stay in the 25% bracket. But if you convert, say, $20,000, you'll pay 28% on the additional $4,250. That extra 3% will cost $128.
Name a Beneficiary
One day you will die, but your IRA can live on. If you fail to name a beneficiary, the proceeds of your retirement account will be subject to probate fees – and, potentially, any creditors you have – and tax-deferred compounding is cut short. But a beneficiary can stretch out tax deferral by taking distributions based on his or her statistically expected lifespan. Moreover, a spouse can roll over your IRA into a new account and won’t have to begin taking distributions until he or she reaches age 70½ (and your spouse can then leave the account to his or her own beneficiary, which recalibrates the distribution requirement). If you want to name more than one beneficiary, divide your IRA into separate accounts, one for each person named.
The Bottom Line
Though the principles of managing an IRA are simple, the process, with its arcane rules and complicated forms, can be very complex. Take care when filling out the paperwork, and consider consulting a tax and estate strategist before going too deep.