If you're saving for retirement in an IRA, good for you! According to the 2016 TIAA IRA Survey, only 33% of American adults have one. Still, just having an IRA (or two!) isn't enough. IRAs have the power to deliver considerable retirement income in the future, so you'll want to make the most of them.
Here's a quick review of some of the most critical errors that people make regarding their IRAs. See if any of them are true for you, and take steps to correct them.
You're contributing to the wrong type of IRA
Let's first review just what IRAs are and how they work. There are two main kinds of IRAs -- the traditional IRA and the Roth IRA. (You can find good administrators of both kinds of IRAs in our IRA Center .)
With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $75,000 and a $5,000 contribution? You'll only report $70,000 in taxable income for the year.) The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement. Many of us will be in lower tax brackets in retirement, so not only is our taxation postponed, but it's often reduced.
With a Roth IRA, you contribute post -tax money that doesn't reduce your taxable income at all in the contribution year. (Taxable income of $75,000 and a $5,000 contribution? Your taxable income remains $75,000 for the year.) Here's why the Roth IRA is a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement -- tax free .
Which kind of IRA will serve you best? Well, it depends. If you're in a steep tax bracket now and expect to be in a low one in retirement, a traditional IRA will help you pay less in taxes. If you're many years from retirement, a Roth IRA might serve you best, as it will let your contributions grow for a long time, into a nest egg that can be tapped tax-free.
Give required minimum distributions (RMDs) some thought, too. Once you turn 70 1/2, you must begin taking RMDs from your traditional IRA(s) -- or face stiff penalties. Roth IRAs don't feature RMDs. If you don't want to be told when to take money out of your IRA or you want to delay tapping it until you're well beyond age 70 1/2, then you might favor the Roth IRA.
Note that there are some special IRA options for the self-employed , too.
You're not maxing out your IRA contributions
Another common IRA mistake is not contributing as much as you can to yours. IRA contribution limits for both 2016 and 2017 are the same: $5,500. There's also an extra $1,000 "catch-up" contribution permitted for those age 50 or older, letting those folks sock away as much as $6,500 for the year. (Note that if you have several IRAs, the limit applies to all of them. You can't contribute $5,500 to each, but you can divide that sum between them.)
To get the most from your IRA, contribute as many dollars as possible to it. Sure, sending in $1,000 or even $3,000 can help build a nest egg for retirement. But you can build a bigger and better one by maxing out your contributions.
Check out what regular investments can do over time:
$5,000 Invested Annually
Growing at an Annual Average of 8%
Growing at an Annual Average of 10%
Over 10 years
Over 15 years
Over 20 years
Over 24 years
Over 25 years
Over 30 years
Data source: calculations by author.
Don't skip years, either. It's easy to think that a single missed year won't matter much, but it really can. Note that in the table I included totals for growth over 24 years and 25 years. You can see what a difference that single extra year of a $5,000 investment makes -- either $34,000 or $54,000, depending on the growth rate.
If you accumulate an IRA nest egg of, say, $400,000 by retirement and you withdraw 4% of it in your first year and then adjust for inflation, you'll start out with a substantial $16,000 in your first year. (By the way -- I've just described " the 4% rule ," which is a flawed but helpful way to think of how you'll make your money last for about 30 years.)
You're investing too conservatively in your IRA
Finally, as the table suggests, it's important to invest the money in your IRA in an effective way. You could park it all in government bonds, but their interest rates have been woefully low for many years, though they're starting to inch up. Your long-term dollars -- ones you won't be needing for at least five years, if not 10 or more -- will likely grow fastest for you in stocks.
Over the long run, stocks simply tend to outperform alternative investments -- by a lot. Check out this data from Wharton Business School professor Jeremy Siegel, who has calculated the average returns for stocks, bonds, bills, gold, and the dollar, between 1802 and 2012:
Annualized Nominal Return
Data source: Jeremy Siegel, Stocks for the Long Run.
The annualized rate for stocks from 1926 to 2012 was 9.6%, by the way. Siegel's data shows stocks outperforming bonds in 96% of all 20-year holding periods between 1871 and 2012, and in 99% of all 30-year holding periods. You can be in a wide range of stocks easily via inexpensive index funds, such as the SPDR S&P 500 ETF (NYSEMKT: SPY) .
It's not enough to just have an IRA and to contribute some money to it now and then. For maximum results, contribute as much as you can to it, and invest that money effectively. The average Social Security retirement benefit was recently $1,360 per month, or about $16,000 per year. You may be able to build an income stream about that big or bigger with an IRA.
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