When Not to Put Money in an IRA

By Chuck Saletta Markets Fool.com

An IRA can be an incredible tool to help you save for your retirement. The money you invest in it can grow tax deferred until you retire. In addition, with a Traditional IRA, you may get a tax deduction when you contribute to it, and with a Roth IRA, can can withdraw money from it tax-free once you reach retirement age.

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Still, despite the benefits that IRAs offer, there are a number of good reasons you might be better of not putting money into your IRA. Some are based on legal rules that restrict your contributions, and others are based on your on individual financial circumstances. It's important for you to understand when those conditions might apply to you. That way, you can enjoy the benefits of investing in your IRA without running afoul of the rules or finding yourself strapped for cash in the short term while you've got money locked out of your reach in a retirement plan.

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No. 1: You're not earning a paycheck or contracting income

To contribute to an IRA, you need to be earning what's known as "taxable compensation." That typically comes in the form of hourly wages, a salary, or independent contractor-style income. Dividends, capital gains, interest or other forms of investment income don't count, nor does simply taking money out of your existing savings or investment accounts. Note that alimony can count as taxable compensation, if it is taxable to the recipient.

If you're married and file your taxes jointly, you can use your spouse's taxable compensation to qualify to contribute to your own IRA. That allows both spouses in families with a stay-at-home parent to contribute. It also in cases such as those where one spouse is in school full time while the other works.

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No. 2: You've already maxed out your contribution

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If you're under age 50, you're allowed to contribute $5,500 per year to your IRA as of 2017. Once you reach age 50, the contribution limit generally increases by $1,000 a year, thanks to catch up contribution rules. In addition, you and/or your spouse must have sufficient taxable compensation to cover the amount being contributed.

For instance, assume both you and your spouse decide to retire in January and together only bring home $7,000 in taxable compensation for the year. That $7,000 represents the most both of you can contribute in total across both of your IRAs for the year, while neither one of you can contribute more than the individual limit of $5,500 or $6,500 depending on your ages.

No. 3: You're too old or are making too much money

There are no age restrictions for contributions to Roth IRAs, but there are income restrictions. Traditional IRAs have no income restrictions, but do have age restrictions for contributions. While most working people should be able to contribute to at least one of them, once you're 70 1/2 years old, you lose your ability to contribute to a Traditional IRA.

The table below shows the income limits for Roth IRA contributions. Those limits, when combined with the Traditional IRA age restriction, are what make it possible for you to be too old and earn too much to contribute to an IRA. But fear not: Even if you do find yourself ineligible to contribute due to that combination, you can still invest in an ordinary brokerage account and simply earmark the funds for your retirement.

Source: Internal Revenue Service (for tax year 2017)

No. 4: You're drowning in debt

While an IRA can be an incredible tool to help you save for your retirement, it's one you should only contribute money to if the rest of your financial situation is under control. If you've got high-interest-rate debt like credit cards or medical debts, you should get those paid off before investing.

After all, the long term return you'll gain by investing in stocks is unlikely to exceed the rate of around 10% annually that the market has achieved historically. Since in interest you'll pay on credit card debt can easily exceed 20%,any spare money you have should be put toward digging yourself out of that type of debt before you consider investing.

If your debt is in the form of low-interest-rate student or car loans, or a mortgage, and you have a fair shot of accruing returns that outperform the costs of that debt, you should carefully consider whether to invest or pay down the debt. If your debt service costs are eating up so much of your income that you can't cover the minor financial curve balls that life throws your way, you can't afford to invest, no matter what interest rate you're paying on your debt.

No. 5: You've got enough socked away for retirement already

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An IRA can be awesome for helping you save for retirement. Still, once the sum in your IRAs and other qualified retirement accounts reaches the point where it's capable of covering your costs in retirement, it may make sense to invest elsewhere. Some of the features that make IRAs so good as vehicles for retirement investing mean that they're not necessarily the best places for money that you'll be using for other purposes.

For instance, if you want to tap the money in your IRA before you're 59 1/2, you run the risk of paying a 10% penalty on top of ordinary income tax for your withdrawals.

In addition, Traditional IRAs are subject to mandatory minimum withdrawals starting at age 70 1/2, and those required withdrawals get larger as a percentage of your account balance every year thereafter. Those withdrawals count as ordinary income for tax purposes. If your income gets high enough, it can expose more of your Social Security income to tax, and cause your Medicare premiums to rise. Roth IRAs are not subject to those mandatory minimum withdrawals.

And finally, after you pass away, your heirs pay income taxes as they withdraw money your Traditional IRA, and most heirs are required to take distributions whether or not they need the money. Money in an ordinary brokerage account gets assessed on a 'stepped up basis' at the time of death, which can lower the tax burden for the recipient, and there are no mandatory sales for ordinary investments.

Use IRAs as the great retirement tool they're meant to be

Despite those occasions when you can't or shouldn't contribute to an IRA, they can be incredible tools to help you build your retirement nest egg. Simply contribute when you're able to and it makes sense to do so, invest the money within its tax deferred shelter, and watch it grow. Once you've retired, you'll be glad you did.

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Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.