3 Ways You Can Make Your IRA Work Better for You
Regular IRA contributions aren’t enough to ensure a secure future. You need to put your money to work for you. That might sound complicated to those who aren’t experts at investing, but there are a few simple things anyone can do to get more out of their IRA so they can have more money for retirement. Here’s a closer look at three of them.
1. Choose the right type of IRA
When you open an IRA, you must decide whether you’d like it to be traditional or Roth. Traditional IRAs use pre-tax dollars. That means your contributions reduce your taxable income for the year, but in exchange, you must pay income tax on your withdrawals. Roth IRAs use after-tax dollars, so contributions to these accounts won’t lower your tax bill this year, but then you won’t owe taxes on your distributions later.
Traditional IRAs usually make more sense for those who think they’re earning more money now than their expect their taxable income will be annually in retirement. By delaying taxes until later when your income is lower, you’ll hopefully hold on to a larger percentage of your savings.
Roth IRAs are better if you think you’re earning less or about the same as what you’ll spend annually in retirement. Paying taxes now on just your contributions will save you money compared to paying taxes on all of your withdrawals later, especially if your income is higher later in life.
Those who already have traditional IRAs may convert to a Roth IRA if they decide this is the better option for them. But doing so requires paying taxes on the converted sum in the year of the conversion. So if you decide to change $5,000 in traditional IRA funds to Roth IRA funds this year, you will have an extra $5,000 tacked on to your tax bill for the year.
Converting from a Roth IRA to a traditional IRA isn’t possible, so if you decide you prefer traditional IRAs instead, you will have to open one of these separately.
2. Keep your investment fees as low as possible
Fees are an inevitable part of investing, but you can control how much you’re paying. First, you should figure out what your current fees are. Your prospectus should tell you about any costs associated with your investments, and you can check with your broker to learn about the fees it charges you for managing your IRA.
You might see fees listed as a set dollar amount, but it’s more common to see them as a percentage of your assets. If you’re invested in a mutual fund with a 1% expense ratio, for example, that means that for every $100 you have invested in that mutual fund, you’re giving up $1 to cover the fees associated with it.
You don’t want to pay more than 1% of your assets, because that’s hurting the long-term growth of your savings. Consider changing your investments if you find out you’re paying more than this in fees annually.
Index funds are a great, affordable option. These are mutual funds that track a market index, like the S&P 500 index. They contain more or less the same funds as the index, so when the index performs well, so does the fund. Historically, they’ve generated strong returns, and they usually have pretty low fees because fund managers don’t have to buy or sell assets as often as they do with some other mutual funds. They also provide instant diversification, so you’re not at risk of losing everything if a single investment is performing poorly.
3. Contribute as much as you’re able to
Contributing more to your IRA will help your savings grow more quickly. If your goal is to retire as soon as possible, you should put as much as you can into your IRA every year. But there are a few things you need to watch out for.
IRAs have annual contribution limits. In 2020, you may only contribute up to $6,000 to an IRA if you’re under 50 or $7,000 if you’re 50 or older. If you accidentally exceed this limit, you must remove the excess contribution and any earnings associated with it, or the IRS will charge you a 6% excise tax per year.
If you have a Roth IRA, you must also be mindful of income limits. These restrict how much high earners can contribute directly to the account. Who is considered a high earner depends on your tax filing status. Here’s a guide to Roth IRA income limits to help you figure out if this is something you need to worry about. If the IRS does classify you as a higher earner, you may not be able to contribute up to the annual contribution limit for the year or you may not be able to contribute anything to your Roth IRA directly.
High earners may still contribute to a Roth IRA indirectly by making a traditional IRA contribution and doing a Roth IRA conversion in the same year. This is called a backdoor Roth IRA. It’s a few extra hoops to jump through, but it gets you to the same place in the end.
The three steps above will help you get more from your IRA, but you can’t just do them once and never look at them again. Your income will likely fluctuate over time, as will your risk tolerance and goals for retirement. You need to adapt your investment strategy to match these changes. Review your retirement plan at least once per year and make adjustments as necessary to keep yourself on track.
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