Don't Let IRA Contribution Limits Wreck Your Retirement Dreams

Just because the IRS limits the amount you can contribute to your IRA doesn't mean that's all you should be saving for retirement.

Sep 3, 2014 at 1:59PM

Money Tree


As of the 2014 tax year, the IRS limits the amount you can contribute to your individual retirement accounts (traditional or Roth) to a total of $5,500, or $6,500 for those age 50 or older. But don't let these IRA contribution limits set a cap on your retirement savings. For many people, especially those who have gotten a late start on retirement savings, simply maxing out your IRA contributions won't produce enough of a nest egg to last throughout a lengthy retirement -- even if you invest wisely.

Fortunately, there are some other ways to set aside money with similar benefits to IRAs. Here are the best places for your additional retirement savings that you can use.

Why your IRA might not be enough
Let's say that you're 35 and you contribute $5,500 per year to an IRA for the next 15 years, and then bump your contributions up to $6,500 after you're 50. Assuming 8% average annual returns on your investments, you can expect to retire at 65 with just over $700,000 in savings. Sounds like a lot, right?

But depending on how much income you need in retirement, this may not be enough. Many experts say you should plan to withdraw 4% of your nest egg each year in retirement in order to maximize the chances that your money will outlive you. While I think this is a bit conservative -- as I've written before -- it's always best to err on the side of caution.

So, 4% of $700,000 is $28,000 per year. Even if you bump up your withdrawals a bit to 5%, that's still just $35,000 in annual income. The average Social Security benefit is currently $1,294 per month ($15,528 per year), so at best, you're looking at about $50,000 per year in retirement. Is this enough to live the kind of lifestyle you want?

Your employer may help
If your employer offers a 401(k) or other tax-advantaged retirement plan, at a bare minimum, you should be contributing as much money as your employer is willing to match.

But if you've maxed out your IRA contributions and still have money to invest, consider increasing your 401(k) contributions. The IRS currently allows elective employee contributions (not including any employer match) of up to $17,500 to a 401(k) account. And some employers have additional retirement options beyond 401(k) plans. Contact your company's benefits department to see exactly what you have to choose from.

What if you are self-employed?
If you are self-employed, there are special types of accounts you can open to boost your retirement savings. Basically, there are three main options: a SIMPLE IRA, a SEP-IRA, or an individual 401(k).

As the name implies, a SIMPLE IRA is the most straightforward of the options, allowing account holders to set aside up to $12,000 in addition to their normal IRA contributions, making the total retirement savings contribution limit $17,500 per year.

A SEP-IRA, which stands for Simplified Employee Pension, allows you to contribute the lesser of 25% of your compensation or $52,000 for 2014. An individual 401(k) plan allows for the same amount in contributions as a SEP-IRA, but the rules are a little more complex. And with a 401(k) you can do things you're unable to do with an IRA, such as borrow money from your account without a penalty.

Whatever your situation, contact a financial professional to determine what's best for you. And read this article for a more thorough description of each plan.

When all else fails, a regular brokerage account works for some investments
If you've maxed out your tax-advantaged retirement savings options and still have some more money to set aside, a regular, taxable brokerage account can work for some retirement investments.

Your highest-dividend stocks should generally be reserved for your tax-advantaged accounts. One of the biggest advantages of an IRA or 401(k) is that your money is allowed to compound on a tax-deferred basis, meaning you don't have to pay taxes on your dividends each year. Because of this, if you reinvest your dividends, your money can compound a lot faster. Meanwhile, in a taxable account, you may have to pay 10% or more on dividends based on your income and how long you have held the stock.

And perhaps most importantly, a taxable brokerage account is best used for investments you plan to hold for more than a year. If you sell a stock a year or less after purchasing it, your capital gains will be taxed at the same rate as your income. But capital gains on investments held longer than a year are taxed at significantly lower rates. For taxpayers in the 10% and 15% brackets, there is no tax on long-term capital gains, and for most other tax brackets, the rate is 15%. The highest tax bracket (39.6%) pays a 20% tax on long-term capital gains -- still only about half their income tax rate.

These tax considerations are among the many reasons we at the Fool advocate a buy-and-hold strategy.

The bottom line
An IRA is an excellent start, but if you can afford to set aside even more money for your retirement than the IRA contribution limits allow, it's always a good idea. Take advantage of your tax benefits and use the accounts that fit your situation the best, and you'll be well on your way to your dream retirement.

Use tax advantages to create even more income for your retirement
Social Security plays a key role in your financial security, but it's not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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