Over 46.4 million American households use IRAs to stash a portion of their retirement savings, but despite this widespread use, there are still plenty of misconceptions about how they work. This can cause people to make poor decisions that hurt their savings' growth or land them in trouble with the IRS. If you don't want that to happen to you, make sure you understand the five IRA rules outlined below.
1. Roth IRAs have income limits
The government prohibits high-earning individuals and couples from contributing directly to a Roth IRA. How much you can contribute depends on your modified adjusted gross income (MAGI), which is your adjusted gross income (AGI) with certain tax deductions back in.
Most people may contribute up to $6,000 to a Roth IRA in 2020 or $7,000 if they're 50 or older. But individuals with MAGIs of $124,000 or more and married couples with MAGIs of $196,000 or more may only be allowed to contribute a reduced amount, or they may not be able to contribute any money directly to a Roth IRA.
These income limits change slightly every year. If you'd like to contribute to a Roth IRA in 2020, you must make sure you fall below the above limits, or the IRS will hit you with penalties for excess contributions.
You could use a traditional IRA instead. These have the same contribution limits as Roth IRAs, but anyone who earns income or is married to someone who earns income can use one. The difference is that traditional IRAs use pre-tax dollars, so you pay taxes on your withdrawals, but not on your contributions, while Roth IRAs use after-tax dollars. That means you pay taxes on your contributions, but not your withdrawals.
2. The IRA contribution deadline is later than the deadline for 401(k)s
You must make all of your 2020 401(k) contributions by Dec. 31st, but you have until April 15, 2021 to stash money in your IRA. So if you finish the year with some extra cash or you get a bonus from your job that you'd like to put away for retirement, your IRA is a great place to do that.
Just make sure your IRA provider applies your contribution to the correct year. It may default to a current-year contribution for 2021, and then you must reach out to change it to a 2020 contribution so it's recorded correctly. Otherwise, it will count toward your 2021 contribution limit instead.
3. You must wait longer to begin taking penalty-free withdrawals from IRAs than from 401(k)s
You can begin taking penalty-free withdrawals from your 401(k) at 55, thanks to a special provision known as the Rule of 55. But there isn't a similar option for IRA owners. They must wait until 59 1/2 to begin taking withdrawals, or else they'll pay a 10% early withdrawal penalty.
That penalty is waived in 2020 because of the pandemic. It's also waived in normal years for things like medical expenses that exceed 10% of your AGI, money used for a first-home purchase, and if you become disabled. None of these exceptions get you out of paying taxes on your savings if it comes from a traditional IRA, though.
4. You're required to take withdrawals from your traditional IRA
Traditional IRAs, like employer-sponsored retirement plans, have required minimum distributions (RMDs). These are mandatory amounts you must withdraw every year beginning the year you turned 70 1/2 if you reached this age before 2020, or beginning at 72 if you'll reach this age after 2020.
You determine your IRA RMD by dividing your account balance by the distribution period next to your age in this table. So if you have $50,000 in your traditional IRA and you're 72, you'd divide the $50,000 by the 25.6 distribution period for 72-year-olds, and you'd get about $1,953. You must take out at least this much this year, or you'll pay a 50% penalty tax on the amount you failed to withdraw.
5. You're responsible for making the decisions about your investments
You probably already knew this, but it's something that most people don't think too much about. With a workplace retirement plan, your employer does most of the hard work as far as selecting investment choices, and it may give you relatively hands-off options like target-date funds, which have assets that change over time to match your declining risk tolerance as you age.
With an IRA, it's all on you to make the right decisions for your money. That means choosing the investments that you believe will make you the most money without exposing you to undue risk. You also have to be mindful of fees, as these can eat into your profits. Getting either of these things wrong could make it much more difficult for you to save what you need for retirement.
When using an IRA, you must educate yourself about how to invest effectively and check in with yourself at least once per year to decide if you need to make any changes to your portfolio. It may sound like more work, but doing this and keeping the other rules discussed here in mind is essential if you want to get the most out of your IRA.