3 Common IRA Mistakes that Steal Your Wealth
Are misunderstandings about IRA accounts keeping you from financial security? Money Girl covers 3 of the most common mistakes that may be preventing you from using IRAs to build wealth.
One of the best ways to save for retirement is to make regular contributions to an Individual Retirement Arrangement or IRA. Although these special, tax-advantaged accounts are available to just about every American with income (including non-earning spouses), many are passing them up.
Some simple misunderstandings about how IRAs work may be keeping you from shoring up your financial security. In this episode, I’ll tackle 3 common mistakes you should be aware of, so you can use IRAs to successfully build wealth.
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Recently, I was invited to make a speaking appearance at the University of North Georgia on the topic of creating financial independence. During my Q&A session, it was clear that many students were anxious to start building wealth—but some were also hesitant.
Fortunately, their concerns revealed misunderstandings about the rules for using an IRA. Of course, I was thrilled to clear up those misconceptions, and put their minds at ease about getting started.
Today, I want to bust through those misunderstanding for Money Girl readers and podcast listeners, as well. Investing through a retirement account is just too good an opportunity to miss!
What Is an Individual Retirement Arrangement (IRA)?
In a nutshell, an IRA is a type of account that allows you to make tax-advantaged investments for retirement. That means owning investments within an IRA saves you money on income taxes and capital gains taxes, and ultimately allows you to save more for the future.
Any time you have an opportunity to delay taxes or eliminate them altogether using a tax-advantaged account, please take advantage of it! Otherwise, you’re giving away money to the government for no good reason, instead of keeping it for yourself and your family.
For 2014 and 2015, the annual contribution limit for all your IRAs is $5,500. If you’re age 50 or older, you qualify for an additional catch up contribution of $1,000, for a total allowable limit of $6,500 per year.
Here are 3 common mistakes that should never keep you from building wealth with an IRA:
Mistake #1: Believing Contributions Are Required
With any type of tax-advantaged account – such as an IRA, a workplace retirement account, or a Health Savings Account (HSA) – you’re never required to make ongoing contributions.
In other words, you could open up an IRA and then never contribute another penny, if you like. There’s no rule that requires you to add money to the account every year to keep it open, or to qualify for tax advantages.
With an IRA, there may be some minimum amount needed to open your account, such as $50 or $100. But many investing services like Betterment, Motif, and E*TRADE have no annual fees or account minimums.
So in theory, you could make a small, one-time contribution and let it grow forever. Let’s say you invested just $100 in an IRA earning an average annual return of 7%. If you never made any additional contributions, your $100 would grow to a balance close to $1,500 over a 40-year time period.
But here’s the power of making small investments over time: If you contributed $100 a month for 40 years with a 7% average return, you’d amass over $260,000. And if you contributed the current IRA maximum of $5,500 per year instead, you’d have over $1 million!
So don’t worry that opening an IRA could cause a financial hardship down the road if your situation changes and you can no longer make contributions. Whether you add money to a retirement account or not is completely up to you.
Also see: 10 IRA Facts Everyone Should Know
Mistake #2: Getting Stuck on the Type of Account to Open
There are 2 main types of IRAs for individuals: a traditional and a Roth. I see many people get into “analysis paralysis” about the differences between them, and end up doing nothing to achieve their financial goals for retirement.
Here are the major differences:
- A traditional or regular IRA allows you to make contributions that are generally tax-deductible. Neither the money you put in nor earnings in the account are taxed until you take distributions.
- A Roth IRA does not allow tax-deductible contributions; you must contribute on an after-tax basis. However, there’s never any additional tax on contributions or earnings in the account. In other words, your distributions are completely tax free.
You can see a side-by-side comparison of the full list of IRA rules at IRS.gov.
Additionally, to contribute to a Roth IRA you can’t earn over a certain amount. Here are the Roth IRA income thresholds by tax filing status for 2015:
- Married filing jointly or qualifying widow(er): your modified adjusted gross income must not be $193,000 or greater.
- Single, head of household, or married filing separately and living separately: your modified adjusted gross income must not be $131,000 or greater.
- Married filing separately but living together: your of modified adjusted gross income must not be $10,000 or greater.
So what happens if you open up a Roth IRA, but later earn too much to qualify for it? No big deal. You keep the account as-is, but can’t make any new contributions to it.
It’s kind of like hitting the pause button on being a contributor, but you still own the account. You never lose any money, tax advantages, or control over a Roth account.
If you’re eligible to contribute to a Roth IRA, it’s the best choice if you believe that your tax rate is lower today than it will be in retirement.
Not qualifying to contribute to a Roth IRA because your income is too high is a terrific problem to have! And in the future, if the limit goes up, or your income goes down below the annual allowable amount, you can start making Roth IRA contributions again to the same account.
Should I Have a Traditional or Roth IRA?
If you’re eligible to contribute to a Roth IRA, it’s the best choice if you believe that your tax rate is lower today than it will be in retirement. If that’s the case, paying tax upfront on Roth contributions will save money compared to paying a higher tax rate on distributions from a traditional IRA in retirement.
But if your tax rate is likely to be lower during retirement, using a traditional IRA allows you to get a tax break now, when your tax rate is higher. If you have no idea about what might happen in the future, hedge your bets by contributing to both.
If you’re eligible for a Roth IRA, you can divide contributions between it and a traditional IRA in any amounts – as long as you don’t exceed the annual limit (including the catch up contribution.) For instance, if you’re younger than 50, you could put $3,000 in your Roth and $2,500 in your traditional IRA.
Mistake #3: Confusing an IRA with an Investment
The third mistake is thinking that an IRA itself is a kind of investment. Remember that a retirement account is simply a place to put your investments.
Imagine a basket full of apples and oranges. The basket is the IRA, and the apples and oranges are the different investments you hold inside it.
You can own a wide variety of investments and savings vehicles in an IRA, such as individual stocks and bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposit (CD), and money market accounts.
The IRS does prohibit you from owning some kinds of investments in an IRA, such as life insurance, collectibles, and certain types of personal property.
See also: 4 Radically Simple Places to Invest Your Money
Should You Save for Retirement Using an IRA?
The only downside to saving for retirement using an IRA is that there may be a penalty if you take money out before reaching age 59½. So never invest money in a retirement account that you might need to spend before then.
If any of 3 misconceptions I’ve covered are the reason why you don’t have an IRA, it’s time to start investing for your retirement and building wealth today.
More Money Resources
IRS Publication 590, Individual Retirement Arrangements (IRAs)
Investment Tips: How and Where to Invest (the Easy Way!)
8 Tips to Invest Without Too Much Risk
7 Investment Rules to Make Money
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
