82% Of Americans Are Making a Big Retirement Mistake. Dont Be One Of Them!

By Markets Fool.com

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Source: 401kcalculator.org via Flickr.

According to a recent TIAA-CREF survey, only 18% of Americans are actively contributing money to an IRA. While many people have other sources of retirement income, such as pensions and 401(k) plans, this number is way too low. An IRA is one of the best tools you have to create the retirement of your dreams, and you should be taking advantage of it. Here's what you need to know about IRAs and how they can dramatically improve your retirement.

Why aren't people using IRAs?
There are many reasons more than four-fifths of American adults aren't contributing to an IRA, including:

  • They have a retirement plan at work, and think that will be enough.
  • Even worse, many people rely on Social Security to provide the bulk of their retirement income.
  • They don't think they can afford to save enough to make it worthwhile.
  • They don't trust investments, and prefer to keep their money in a savings account, CD, or other safe place.

However, none of these are good reasons. Unless you are one of the few "401(k) millionaires" or are willing to accept a lower standard of living in retirement, your employer's retirement plan might not be enough. And who knows what the state of Social Security will be by the time you're ready to retire.

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Also, as we'll see, even a little bit of savings can make a big difference if you start early. Finally, there is no reason not to trust investments as long as you're investing for the long term, and keeping your money in a savings account is about the worst thing you can do. Savings account interest rates are next to nothing, and inflation will actually make your savings worth less over time.

IRA basics
An individual retirement arrangement, or IRA, is a special type of investment account designed to help people save for their retirement.

Account holders can contribute a certain amount of money per year ($5,500 in 2015) and are allowed an additional "catch-up" contribution of $1,000 per year if they're over 50. Once the money is in the account, it can grow and compound on a tax-deferred basis, meaning you won't have to pay taxes on your dividends each year or claim the capital gains in your IRA on your tax return.

You can invest your contributions in virtually any stock, bond, or mutual fund that trades on a major exchange, and some IRAs can even be used to invest in real estate or a business.

There are two main types of IRAs: traditional and Roth. The main difference between them boils down to how your contributions are taxed.

Traditional IRAs could give you a tax break now
A traditional IRA allows qualified individuals to deduct their contributions on their current tax returns, up to the annual maximum contribution limit.

Whether you qualify for the tax deduction depends on your income level and whether you are eligible to participate in a retirement plan at work. Single taxpayers who are not eligible for a workplace retirement plan automatically qualify for a traditional IRA tax deduction, regardless of income. And, even if you have an employer-sponsored retirement plan, you can still qualify if your annual income is less than $61,000 ($98,000 if you're married).

Married taxpayers, if neither spouse is eligible at work, are automatically qualified for the deduction. If one or both spouses are eligible for an employer's plan, eligibility for a traditional IRA tax deduction is based on income. Check the table below, which shows the traditional IRA tax deduction "phaseout" income amounts, to see if you might be eligible:

Eligibility for other retirement plans: Single Married filing jointly Head of household Married filing separately
Eligible to participate in plan(s) at work $61,000-$71,000 $98,000-$118,000 $61,000-$71,000 $0-$10,000
Your spouse is eligible for a plan at work, but you are not N/A $183,000-$193,000 N/A $0-$10,000
Not eligible to participate in an employer's plan Unlimited Unlimited Unlimited Unlimited

Note: The lower amount in each category is the maximum income level for a full deduction, and the ability to deduct contributions disappears completely above the higher amount.

The downside to a traditional IRA is that your withdrawals (once you retire) are subject to income taxes.

A Roth IRA lets you enjoy tax-free retirement income
Contributions to a Roth IRA are never tax deductible, but your qualified withdrawals are tax-free. And, since you've already paid taxes on your contributions, you are free to withdraw them (but not your investment gains) without penalty at any time.

To be eligible to contribute the maximum amount to a Roth IRA, your income must be less than $116,000 if you're a single taxpayer, or $183,000 if you're married filing jointly. However, if you don't qualify for a direct contribution, there is a "backdoor" method you could use by converting a traditional IRA. This can be a little complicated when it comes taxation, so read the linked article for a more detailed explanation if you're interested.

Many people prefer a Roth IRA because it creates a degree of certainty on your tax rates. In other words, you know what your income tax rate is now. Nobody knows what it will be when you retire. For all you know, it could double between now and then. With a Roth IRA your retirement income won't be affected by any future changes in tax rates.

Early and often
Both types of IRAs are good options, and the most important thing is that you start contributing as soon as possible. Consider that if you contribute the maximum amount of $5,500 to an IRA each year (about $460 per month) for 30 years, it could grow to more than $800,000, based on the S&P 500's historical average annual return.

The bottom line is that instead of relying on a 401(k) or Social Security to get you through retirement, an IRA lets you take charge and create the retirement you want.

The article 82% Of Americans Are Making a Big Retirement Mistake. Dont Be One Of Them! originally appeared on Fool.com.

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