An Individual Retirement Account (IRA) can be a potent tool for retirement savings.

Key Takeaways

  • To get the most from your IRA, start funding it as early as possible, even if you can't afford the maximum amount.
  • By contributing to your IRA at the beginning of the year—rather than waiting until April 15 of the following year—you gain up to 15 extra months of potential growth.
  • When you're deciding what to invest in, consider your IRA in the context of your entire portfolio, including employer retirement plans and any other accounts you have.

How IRAs Work

With a traditional IRA, your annual contributions (up to $6,000, or $7,000 for those age 50 and over, as of 2019) are often tax-deductible, providing an immediate benefit. Your investments grow tax-deferred and are only taxed when you withdraw them from the account—an additional benefit if you end up in a lower tax bracket than when you were working. You must begin taking mandatory withdrawals beginning after age 70½. Traditional IRAs are available to any income-earning individual as well as non-earner spouses (through a separate spousal IRA), but the extent to which contributions are deductible is subject to income limits if either spouse has an employer-sponsored retirement plan at work. 

The other type of IRA, the Roth IRA, works much the opposite. You won't receive a tax deduction for the money you contribute, but when you begin to make withdrawals, they will be tax-free if you meet certain conditions. Roth IRAs are subject to a different set of income limits. However, both types of IRA permit accounts for non-earner spouses.

Whichever type of IRA you choose (and you can have both), you can maximize your returns by following some simple strategies.

1. Start Early

Compounding money is a snowball effect, especially when it's tax-deferred or tax-free. Your investment returns are reinvested and generate more returns, which are reinvested, and so on. The longer your money has to compound, the larger your IRA account should grow.

Don’t be paralyzed if you can’t contribute the maximum amount in any given year. “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.”

2. 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, you not only deny your contribution the chance to grow for as much as 15 months, but 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 a longer period, though for stocks, in particular, the risk of buying at a peak remains. Instead, Shah recommends making equal monthly contributions throughout the tax year, using 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.

3. Think About Your Entire Portfolio

Your IRA is probably just part of the money you're setting aside for the future. Some of that money may be in regular, taxable accounts. Financial advisers often recommend distributing investments across accounts based on how they'll be taxed. Traditionally, that's meant bonds, whose dividends are taxed as ordinary income, belonged in IRAs, to postpone the tax bill. Stocks and other assets that generate capital gains—and are taxed at lower rates—belonged taxable accounts.

But in practice, according to financial advisor Michael Kitces, it isn't always that simple. For example, an actively managed mutual fund, which may spin off a lot of taxable capital-gains distributions, might do best in an IRA. Passively managed index funds, which are likely to produce much lower capital-gains distributions, might be fine in a taxable account. And it turns out that it doesn't much matter which type of account lower-return assets, such as many types of bonds, go into.

If the bulk of your retirement savings is in an employer-sponsored plan, such as a 401(k), and it's invested relatively conservatively, you might use your IRA to be more adventurous. It could provide an opportunity to diversify into small-cap stocks, emerging foreign markets, real estate, or other types of specialized funds.

4. Consider Converting to a Roth IRA

For some taxpayers it may be advantageous to convert an existing traditional IRA into a Roth IRA. 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 you plan to hold for a long time—30 years or more.

There are no limits on how much money you can convert from a traditional IRA to a Roth, and there are no income eligibility limits for a Roth conversion, either. In effect, these rules provide a way for 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 contributions, you’ll have to pay income tax on that money in the year you convert it to a Roth. For example, if you're in the 22% marginal tax bracket (in 2019 that applies to married couples with a combined income over $78,950 but under $168,400) and convert a $50,000 traditional IRA, you'd owe at least $11,000 in taxes. On the other hand, you'll owe no tax when you take money out of your new Roth IRA.

So it basically comes down to whether it makes more sense to take the tax hit now or later. The longer your time horizon, the more advantageous a conversion may be, because the new Roth account's earnings, which are now tax-free, will have more years to compound. Also, it will save you worrying about the five-year rule, which, for Roths, means the account must be at least five years old for you to take advantage of tax-free withdrawals.

Naming a beneficiary for your IRA can allow it to keep growing even after your death.

5. Finally, Name a Beneficiary

Your IRA can live on even after your death. 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 its tax-deferred compounding will be cut short. Adding a beneficiary not only avoids that but can, in some cases, allow your heir to stretch out tax deferral by taking distributions based on their 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, simply divide your IRA into separate accounts, one for each person.