For retirement savers, an individual retirement account (IRA) is a must-know vehicle in all of its forms. An IRA can come in either pre-tax or post-tax variety, and may or may not be connected with your current employment status. Below, you'll find four misunderstood facts of IRA investing that may help you as 2020 mercifully comes to a close.
1. An IRA is not an investment in itself -- it holds investments
When investors say that they "invest in an IRA," what they really mean is that they hold investments within an IRA. An IRA is not an investment in itself but rather merely an account type with a name reflective of its tax treatment. Knowing this difference reveals a higher level of understanding when it comes to retirement account mechanics and can prevent you from letting some financial salespeople convince you that an IRA has to be invested in a particular type of investment.
Depending on the specific investments held within, your IRA may have outperformed or underperformed someone else's IRA over a particular time period -- even if both are held at the same financial institution. To avoid confusion, it's important to keep language consistent when referring to these accounts and their underlying investments.
2. All IRAs are not created equal
In one simple example, traditional IRAs are significantly different from Roth IRAs due to their tax treatment. Traditional IRAs generally contain money that hasn't yet been taxed. A traditional IRA might also contain money that has been rolled over from a previous employer's 401(k) plan, which works seamlessly because the tax treatment between the two accounts is usually consistent.
Roth IRAs, on the other hand, are retirement accounts containing post-tax money. Once money has been deposited, you'll never again pay tax on investment growth, dividend income, or lump-sum withdrawals. By investing in a Roth IRA now, you're essentially agreeing to pay tax at today's rates in exchange for never having to pay tax again on the same money. If tax rates are to continuously increase in the future, the Roth IRA will be an especially powerful savings vehicle for those looking to tax-optimize their investments.
3. You get extra time beyond the end of the year to contribute to IRAs
Once the clock strikes midnight on Dec. 31, you might think you've missed an opportunity if you didn't contribute to your IRA during the calendar year. Good news: you still have until April 15 of the following year to make your IRA contribution. For instance, if you have extra cash to invest and haven't yet made your 2020 IRA contribution, you can make contributions for 2020 by April 15, 2021.
While you do have extra time to contribute for the previous year, it's best to make your IRA contribution as early on in the year as possible. The logic here is that by depositing money into an IRA sooner, you're giving the money more time to compound in tax-advantaged space. Best practice, in my experience, is to deposit money to your IRA in early January and make it part of your annual routine. If you don't have the full contribution amount available to invest right away, it's also perfectly acceptable to make monthly contributions throughout the year.
4. RMDs begin at age 72
Required minimum distributions (RMDs) refer to the mandatory withdrawals from traditional IRAs after the account owner has turned 72. The reasoning for RMDs is simple: The IRS wants to be certain it will collect its duly owed tax revenue by compelling you to withdraw money from traditional IRAs. By requiring you to withdraw money and levying a stiff penalty of 50% if you don't, the IRS ensures it will collect income tax on a specified percentage of your traditional IRA balance each year.
Roth IRAs, on the other hand, don't come with RMDs. You could hold a Roth IRA forever with no obligation to withdraw, and it can pass to your heirs with no immediate tax consequences. This illustrates another advantage of opening and continuously building a Roth IRA: Once money has been deposited and invested, there is no future tax obligation nor any future requirement to withdraw.
Know the details to be a more effective investor
Details matter in life, and they really matter when it comes to investing. Those who take the time to read the details are likely to be those best equipped to handle money. IRA investing will almost inevitably be part of your retirement plan, so be sure to take the time to understand the facts associated with it.