"Retirement is like a long vacation in Las Vegas. The goal is to enjoy it the fullest, but not so fully that you run out of money."-- Jonathan Clements
The quip above is more true than ever these days, when relatively few of us can look forward to living off of pension income. It's up to us to save and invest for our futures. One retirement-saving tool that shouldn't be overlooked is the IRA, with which you might sock away hundreds of thousands of dollars in a tax-advantaged (and possibly tax-free) way. Here are three IRA rules to know.
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Understand how IRAs work
There are two main kinds of IRAs: the traditional IRA and the Roth IRA. With a traditional IRA, you contribute money on a pre-tax basis. The value of your contributions is subtracted from your taxable income, so it reduces the tax you pay now. (For example, excluding other deductions, if your gross income is $65,000 and you contribute $5,000 to a traditional IRA, your taxable income falls to $60,000.) The money grows tax-deferred until you withdraw it in retirement, when it's taxed as ordinary income.
The Roth IRA offers no upfront tax break, accepting only post-tax contributions. With income of $65,000 and a Roth IRA contribution of $5,000, your income will still be $65,000. But if you follow the rules, it also grows tax-free and is withdrawn in retirement completelytax-free.
It's easy to set up an IRA account. Many financial institutions would love to help you open one with them. Visit their websites or those of any major brokerages, and you can access account-opening information and forms to fill out online or print and mail in.
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Improve your financial security by knowing the key IRA rules
Contributions to IRAs for a given tax year are due by the tax-filing deadline for that tax year, which is usually April 15. This year that falls on a weekend near a holiday, so the deadline for both your federal tax return and IRA contributions is April 18, 2017, for the 2016 tax year.
IRA contribution limits for both the 2016 and 2017 tax years are the same: $5,500. There's also an extra $1,000 "catch-up" contribution permitted for those age 50 or older, letting them contribute as much as $6,500 for the year. Per the rules, you can have multiple IRAs, all Roth, all traditional, or a mix, and can contribute to all of them each year -- as long as you stay within the $5,500 or $6,500 limitin total. In other words, you can spread that contribution across more than one IRA if you want to.
You may not be able to make full use of IRAs if you're a high earner, though. Roth IRAs come with income limits. Single filers can contribute up to the maximum to a Roth IRA if their income is less than $117,000, and an income of between $117,000 and $132,000 will allow them a partial contribution for the 2016 tax year. For the 2017 tax year, those numbersare $118,000 and between $118,000 and $133,000. Married taxpayers filing jointly can contribute the maximum to a Roth IRA if their income is less than $184,000 (with a partial contribution allowed for those with incomes between $184,000 and $194,000 for a partial contribution). In the 2017 tax year, the limits rise to $186,000 and between $186,000 and $196,000. There are no income limits for traditional IRAs. However, there are income limits for tax-deductible contributions.
When it comes to withdrawals, you generally need to have reached the age of 59 1/2. Withdrawing from a traditional IRA before that will cost you a 10% penalty (plus the regular taxes you'd owe on the withdrawal at any time). Before age 59 1/2, you can only withdraw money you contributed to a Roth IRA -- not the earnings from those contributions, nor money you converted into the Roth from a traditional IRA. (Funds converted from a traditional IRA to a Roth IRA need to stay in the Roth IRA for at least five years to qualify for penalty-free withdrawals.) Once you're 59 1/2 or older, you can withdraw money from your Roth IRA as you please -- as long as you first contributed to the account at least five years ago. Note that traditional IRAs (but not their Roth IRAs) feature required minimum distributions (RMDs) beginning at age 70 1/2.
For maximum retirement income, make the most of your IRA
A last IRA rule to heed is to make the most of your IRA(s). For example, Check out the table below, which shows how much of a difference in results you'll experience if you contribute $4,500 every year vs. if you contribute $5,500 every year:
Calculations by author.
You can do even better than the $5,500 column above, as contributions of $6,500 are allowed once you reach age 50 -- and contribution limits for all ages are adjusted every year or few years. So in a decade or more from now, you may be able to contribute $7,000 or $8,000 annually.
Be strategic in how you invest your IRA money, too. A 401(k) account typically restricts you to choosing from among a limited suite of mutual funds, but you can invest in just about any stock or exchange-traded fund (ETF) and gobs of mutual funds through your IRA. But not all stocks or funds are equally sensible for your IRA. Municipal bonds, for example, are already tax-free, so it's not worth socking them in an IRA that saves you taxes on them.
Roth IRAs are good places for stocks you hope will be your fastest growers -- especially if you're a long way to retirement. If they perform as expected, your stake in them can swell to a hefty sum, which you can later withdraw tax-free. Real estate investment trusts (REITs) are also good for Roth IRAs. They tend to generate a lot of dividend income, but much or all of that is often not eligible for the low long-term capital gains tax rate and is instead taxed at your ordinary income tax rate. In a Roth, you'll avoid being taxed entirely.
This doesn't have to be complicated, confusing, or intimidating, though. You can do very well just investing in a broad-market index fund or two, or a target-date fund, in your IRA(s).
An IRA can be a powerful way to save for retirement. For best results, though, be sure you know the rules and how to make the most of it.
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