Increasing numbers of people are setting up self-directed
Individual Retirement Accounts (IRAs), allowing them to call their
own investment shots. Unfortunately, most investors are
short-changing their retirement by being timid.
There's no investment that beats the returns of stocks over the
long-term and an IRA represents a vehicle for long-term money. So
why shoot yourself in the foot by playing it too safe?
According to IRS statistics, about three-fourths of self-directed
IRA money is in money market funds, government bonds or other
fixed-income securities. That defies common sense.
A common "risk-averse" mistake is to put IRA money into tax-exempt
investments, such as annuities, municipal bonds and tax-exempt
money market funds. These investments already are tax-exempt, so
there's no tax advantage to putting them in a tax-favored IRA. It's
a double whammy: The tax-exempt status is bestowed in exchange for
a lower yield, so you're doing yourself a disservice by wasting
tax-exempt benefits on lower potential returns.
Another common mistake investors make is assuming that IRAs aren't
worthwhile for high-income savers. On the contrary: Deductible or
not, any money you deposit accumulates free of taxes as long as it
stays there. This means your savings can grow and compound without
having a big chunk sliced off for current taxes, as would be the
case with an ordinary investment. The result is a pool of money
that grows faster. And tax-deferred compounding gets sweeter the
longer it lasts.
To really take advantage of an IRA, you've got to stay with stocks.
If you're an older person nearing retirement and all you want to do
is invest in cash or fixed-income investments, you're far better
off just buying an annuity outside of the IRA. The bottom line is,
money that won't go into stocks shouldn't go into your IRA.
Sound like heresy? The fact is, IRAs are for retirement investing,
which means you need to take a long-term view, and that almost
always means stocks. The lower rates of return that come with safer
investment options will not begin to compensate you for the extra
record-keeping hassles, costs and restrictions of IRAs, and will
tarnish the luster of tax-deferred compounding.
When it comes to stocks, your best bets are companies with great
growth potential, particularly those in a dominant position in
their markets. In this regard, it's hard to go wrong with some of
the stock recommendations that I've made on InvestingAnswers'
sister site, StreetAuthority.com [click here].
Stocks have historically outpaced other types of investments
because they provide opportunity for growth. Don't let today's
volatile stock market and still-iffy economy frighten you out of
stocks altogether. The advantage of stocks will only increase
during the decade ahead because the stage is still set for moderate
to low inflation .
Self-directed IRA accounts are typically set up through a broker,
but you decide what and when to buy and sell. Call your broker and
he or she will show you how to do it. However, since you're
completely in charge of the account once it's set up, it's
important to follow these basic guidelines:
- Keep track of your returns: Because IRAs are invested for the
long haul, investors tend to neglect regular monitoring of their
returns. Don't fall into this trap of complacency.
- Limit trading: Although you should stay on top of market
conditions, trading too aggressively doesn't make sense. You
can't take a tax deduction for investment losses, nor can you
deduct investment advisory fees and expenses. And remember:
Brokers' commissions are added to the cost of the investment,
which reduces capital gains.
- Limit the number of accounts: Don't take out several IRAs at
different banks, regardless of any enticing yields offered. This
scattershot approach can eat away at your returns by exposing you
to more transaction and account fees than necessary. By putting
your IRAs under one umbrella, you can cut costs, trim red tape,
and make it easier to stay on top of performance. Consolidating
your IRA accounts, before distributions become mandatory at age
70 ½, can also help you keep track of your distributions and
avoid penalties.
- Learn contribution rules and limits: Many IRA investors have
mistaken notions about how much they can save every year. Here
are the latest IRS rules:
- If you are under 50 years of age at the
end of 2010, the maximum contribution you can make to a
traditional or Roth IRA is the lesser of $5,000 or the amount of
your taxable compensation for 2010. This limit can be split
between a traditional and a Roth IRA but the combined limit is
$5,000. The maximum contribution to a Roth IRA and the maximum
deductible contribution to a traditional IRA may be reduced
depending upon your modified adjusted gross income (modified
AGI).
- If you are 50 years of age or older
before 2011, the maximum contribution that can be made to a
traditional or Roth IRA is the smaller of $6,000 or the amount of
your taxable compensation for 2010. This limit can be split
between a traditional and a Roth IRA but the combined limit is
$6,000. The maximum contribution to a Roth IRA and the maximum
deductible contribution to a traditional IRA may be reduced
depending upon your modified AGI.
Don't forget that you'll have to pay taxes on any IRA
withdrawals made before age 59 ½. And the IRS will impose a 10
percent early withdrawal penalty on the taxable portion of your
early IRA withdrawal. For tax-deferred IRAs, this is the entire
amount. For Roth IRAs, the 10 percent penalty applies only to the
early withdrawal of earnings. This is a one-time penalty paid in
the year of the early distribution.
Here's the encouraging news: When people leave the workforce and
start making allowable withdrawals, their income usually drops
sharply-on average about 50 percent. That puts you in a lower tax
bracket.
Finally, remember that in contrast to a traditional IRA,
contributions to a Roth IRA are not tax-deferrable. Withdrawals are
generally tax-free, but not always and not without certain
stipulations. An advantage of the Roth IRA over a traditional IRA
is that there are fewer withdrawal restrictions and requirements.
Transactions inside the Roth IRA account do not incur a current tax
liability . Your broker can fill in the details.
The bottom line? When it comes to a self-directed IRA, play it
smart -- not safe.