Traditional and Roth IRAs provide a tax-advantaged way to invest in stocks, bonds, mutual funds, and a variety of other securities. But there are certain IRA investment strategies that can really boost your retirement savings.
- To get the most from your IRA, start funding it as early as possible, even if you can't contribute 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 choose investments, think about your IRA in the context of your entire portfolio. Be sure to consider any employer retirement plans and other accounts you have.
How Does an IRA Work?
There are two main types of IRAs: traditional and Roth. The most you can contribute to either IRA in 2019 is $6,000, or $7,000 if you're age 50 or older. And you must have "earned income"—money from wages, salaries, or self-employment income—to contribute to either.
Spouses may be able to get around the "earned income" requirement. You can contribute to a spousal IRA on behalf of a spouse who doesn't work for pay. To do so, you must be married and file jointly, and the spouse with earned income must have enough income to cover both spouse's IRA contributions. You can set up a spousal IRA as either a traditional or Roth IRA.
The biggest difference between traditional and Roth IRAs is when you pay your taxes. With a traditional IRA, you get an upfront tax break. You can deduct your entire contribution if you and your spouse don't have a 401(k) or another retirement plan at work. If either one of you is covered by a plan, however, the deduction may be reduced or eliminated.
A traditional IRA grows tax-deferred, but you pay ordinary income tax when you withdraw funds. You have to start taking required minimum distributions (RMDs) by April 1 following the calendar year you turn age 70 ½.
With Roth IRAs, you don't receive an upfront tax break for the money you contribute. But withdrawals are tax-free if you're age 59 1/2 or older and it's been at least five years since you first contributed to a Roth. And there are no RMDs during your lifetime, which makes Roth IRAs ideal wealth-transfer vehicles.
Roth IRAs are subject to income limits that determine how much you can contribute. If you make too much, you can't contribute at all.
Whichever type of IRA you choose (and you can have both), you can boost your nest egg by following some simple strategies.
1. Start Early
Compounding 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 can grow.
Don’t be thwarted if you can’t contribute the maximum amount in any given year. Instead of focusing on how much you can put in, invest whatever you can. Even small contributions can grow your nest egg substantially, given enough time.
2. Don’t Wait Until Tax Day
Many people contribute to their IRAs when they file their taxes, typically on April 15 of the following year. When you wait, you deny your contribution the chance to grow for as many as 15 months. What's more, you risk making the entire investment at a high point in the market.
Making your contribution at the start of the tax year allows it to compound for a longer period. However, for stocks, in particular, the risk of buying at a peak remains.
If you hold stocks in your IRA, it's a good idea to make equal monthly contributions throughout the tax year, using what's known as dollar-cost averaging. This strategy takes the guesswork out of timing the market and also helps you develop a disciplined approach to saving for retirement.
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 (e.g. non-retirement accounts). Financial advisors often recommend distributing investments across accounts based on how they'll be taxed.
Usually, this means that bonds—whose dividends are taxed as ordinary income—belong in IRAs, to postpone the tax bill. Stocks and other assets that generate capital gains—and are taxed at lower rates—belong in taxable accounts.
But in practice, 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 better in an IRA. Passively managed index funds, which are likely to produce much lower capital gains distributions, might be fine in a taxable account.
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 Investing in Individual Stocks
Mutual funds are the most popular IRA investments because they're easy and they offer diversification. Still, they track specific benchmarks and often do little better than the averages.
There may be a way to get higher returns on your retirement investments if you have the skills (and time) to pick individual stocks.
Investing in individual stocks takes more time and research, but it can yield higher returns for your portfolio. In general, individual stocks can give you more control, lower management fees, and greater tax-efficiency.
5. Consider Converting to a Roth IRA
For some taxpayers, it may be advantageous to convert an existing traditional IRA into a Roth IRA. A Roth account often makes more sense than a traditional IRA if you’re likely to be in a higher tax bracket in retirement than you are in now.
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 directly to fund one by rolling over a traditional IRA.
Of course, because 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. And it could be substantial—so look at the numbers before you make any decisions.
Here's a quick example. Say 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 you want to 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. And that includes any money your investments earn.
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 could be. That's because the new Roth account's earnings, which are now tax-free, will have more years to compound. And you won't have to worry about the five-year rule, either.
6. Name a Beneficiary
Your IRA can live on even after your death. If you don't name a beneficiary, the proceeds of your retirement account could be subject to probate fees—and, potentially, any creditors you have. Also, its tax-deferred compounding will be cut short.
Naming a beneficiary for your IRA can allow it to keep growing even after your death.
Adding a beneficiary not only avoids these problems, but it can also (in some cases) allow your heir to stretch out the 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 70 ½. Then, your spouse can leave the account to another 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.
There are separate beneficiary rules, depending on the type of IRA you leave to your heirs. Check with your financial advisor to make sure you're using the most tax-efficient tax strategy.
The Bottom Line
IRAs offer a great way to save for retirement. Although the annual contribution limits are low—just $6,000 for 2019—there are ways to make every dollar count. If you need help maximizing your IRA, be sure to consult a trusted financial advisor.