5 simple rules for investing in an IRA
February 10, 2014
Investing for retirement doesn't have to be complicated. One way to make it easier is to set aside money each year in an IRA. Over time, the tax advantages offered by an IRA can help you accumulate more money for your golden years.
Here are five simple rules to follow:
1. Just do it—contribute!
"Can I still contribute for 2013?"
Yes. For the 2013 tax year, the last day to open a new IRA or contribute to an existing IRA is Tuesday, April 15, 2014.
Be sure to indicate whether your contribution is for 2013 or 2014.
If you're under age 50, the maximum IRA contribution amount for the 2014 tax year is $5,500. You can save even more if you're age 50 or older by making "catch-up" contributions—up to $6,500 for the 2014 tax year. The limits apply to the combined contributions you make to all the IRAs you hold, whether traditional or Roth.
If you're married, your spouse can also make an IRA contribution even if he or she doesn't have earned income. (At least one of you does need to have earned income.)
2. Know the difference between Roth and traditional IRAs
Choosing the right type of IRA hinges on the question of when you want to pay taxes—now or later.
With a traditional IRA, your contributions may be tax-deductible if you meet certain eligibility requirements. Your earnings can then grow tax-deferred until you begin making withdrawals, at which point you'd be taxed at whatever rate you're subject to at the time (which could be higher or lower than your current rate).*
With a Roth IRA, you're contributing after-tax money. You don't get an immediate tax deduction, but your earnings grow tax-free, assuming they meet certain requirements.* For many investors, the appeal of a Roth IRA is obvious: tax-free growth, no lifetime requirements for required minimum distributions (RMDs), and the opportunity for tax diversification. This comparison chart can help you decide.
3. Check the "back door" if your income's too high
"How do I open a new IRA?"
In just a few minutes, your new Vanguard IRA® can be ready to help you meet your retirement investing goals. Why wait?
If you can't contribute to a Roth IRA because your income exceeds the allowable limit, you may be able to take advantage of what's often called a "back door" Roth IRA.
Here's how it works: You fund a nondeductible traditional IRA and then later convert it to a Roth. You're essentially making a contribution to a Roth IRA, and there may be little or no tax impact from the conversion if the account doesn't build earnings. From a tax standpoint, this strategy works best if you don't have other traditional IRA assets that you're not converting.
If you have significant IRA assets funded with pre-tax contributions (from an employer plan rollover, for example), you might not want to open this back door. Federal law requires you to aggregate all your IRA assets for tax purposes, no matter which ones you actually convert, so you might be looking at a tax bite if you use this strategy.
4. Reconsider your use of a nondeductible traditional IRA
For most investors, there isn't really a strong financial case for funding a nondeductible IRA as part of a long-term retirement plan. Although such an account may grow tax-deferred, contributions aren't deductible, and you'll have to pay income taxes on any earnings when you make withdrawals.
If you're eligible to contribute to a Roth IRA, that choice could make more sense. But if you earn too much income to contribute to a Roth and the back-door Roth strategy (see item 3 above) isn't practical, consider tax-efficient investments in nonretirement accounts.
5. Pay attention to costs
Market performance isn't the only thing that affects your IRA's bottom line. Investment costs can have a significant "drag" on your long-term retirement savings. And unlike market returns, which can be positive one year and negative the next, operating expenses keep eating away at your account in good years and bad.
That's why it's important to keep an eye on what you're paying your investment provider. Here's a very rough guideline: If your IRA costs you 1% of assets per year over 30 years, you'll end up "giving away" nearly 30% of what you would have had if those fees hadn't been deducted. (Learn more about why costs matter.)
*If you make withdrawals from a traditional IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax on withdrawals unless an exception applies. Note that the amount you convert to a Roth IRA is not subject to the 10% penalty. With a Roth IRA, distributions of contributions are tax- and penalty-free; however, withdrawals of earnings before age 59½ may be subject to a 10% federal penalty tax and income taxes unless an exception applies.
- All investments are subject to risk, including the possible loss of the money you invest.
- Consider consulting a tax advisor concerning your individual situation.
- Consider the impact on your long-term investment strategy when making any transactions for tax purposes.