Whether you've been saving for decades, or you're just getting started, the best way to invest your IRA today might not be the best way to invest your IRA in 20 years. As time goes by, things change, which can in turn alter the approach for maximizing your returns.
Let's look at some of the different ways to invest your IRA. There are many things to consider, but with a little help you can simplify the process, and that will go a long way toward maximizing your time and returns.
Understanding the kinds of IRAs
This is an important place to start, not only because it can be confusing, but because different factors can make one kind of IRA better for you than another.
First, a couple of general rules about IRAs that help illuminate why you should contribute to your IRA early and often: To start, IRA contributions can reduce your taxes, depending on your income. Furthermore, once the money is in the IRA, it will grow on a tax-deferred basis. Depending on the kind of IRA, you might (traditional IRA) or might not (Roth IRA) pay taxes on the distributions you take in retirement.
Let's talk about the kinds of IRAs:
- Rollover IRA: This account allows you to move your 401(k) from a former employer to somewhere you have better access and control over the money. It's also a great way to consolidate multiple 401(k) or traditional IRAs into a single account.
- Traditional IRA: If you're looking to contribute new money, you can contribute up to $5,500 ($6,500 if you're 50 or over) per year. Depending on your income, and if your employer offers a retirement plan, you might be able to deduct that $5,500 from your taxable income. The contributions grow tax-deferred, but the distributions in retirement are considered taxable income.
- Roth IRA: Similar to a traditional IRA, with similar contribution limits. The difference? No matter your income level, contributions don't reduce your taxable income in the year you make them. However, once you have contributed, the money -- and the returns -- will not be taxed, as long as you don't take early withdrawal. In other words, a Roth provides 100% tax-free income in retirement.
Picking the best kind of account
With all these choices, it might seem daunting to determine which account is best for you. Here are some guidelines to help you decide:
- If you're moving your 401(k) from a former employer, the rollover is the way to go. You can also make further contributions, meaning you might not need to open a second IRA just to contribute new money.
- Traditional IRA: If your (or your spouse's) employer doesn't offer a retirement plan, this kind of account will let you deduct the full $5,500 ($6,500 if you're 50 or older) from your taxable earnings, saving you tax money today, no matter your income level.
- Roth IRA: If your (or your spouse's) employer offers a retirement plan, this is likely the best way to go, since distributions are not taxed in retirement and you could not deduct the contributions from your current income for tax purposes. A Roth might also make sense even if your employer doesn't offer a retirement plan, depending on your current tax and income level. It's a call between whether you want to reduce income taxes today or in retirement.
- Self-employed? A self-employed 401(k) may be the way to go. The maximum contribution levels are much higher -- $18,000 in 2015 ($24,000 if you're 50 or older) -- and can be deducted from your taxable income. Furthermore, since you're both the employee and the employer, you can make matching contributions, bringing the total amount you can contribute to this account to $53,000 ($59,000 if you're 50 or older) this year. You can also set up a Roth 401(k), if you want to give up today's tax savings to reduce taxes in retirement.
Need help finding a broker to set up your account? Go here. Most online brokers will walk you through each step, making the process much easier.
What to invest in?
This is a key topic. A number of factors need to be considered, including:
- How much cash are you investing?
- Will you regularly contribute new money to invest?
- How long do you have before retirement?
- What other sources of income will you have in retirement, such as pensions or Social Security?
If you're just getting started, a low-cost index fund like the Vanguard S&P 500 ETF (NYSEMKT:VOO) is worth considering. It lets you put your money to work immediately, without requiring you to pick individual companies to invest in. This will also mean that you will be diversified, and not overexposed to any single company.
If you have a larger nest egg or plan to make regular contributions, and are willing to dedicate a little more time to your future, investing in individual stocks might be the optimum strategy. If you are looking to generate income from your IRA, investing in dividend-paying stocks is a great way to do so.
Whether you invest in stocks through an index fund or pick individual stocks to buy, there's significance evidence that holding stocks for many years offers the greatest chance at the best returns. However, that's only part of the battle: Putting your IRA contributions in the best kind of account to maximize your returns, and lower your tax bill, could be just as important.
Added together, your chance of having the retirement you want will be much better. Ideas or thoughts? Share in the comments section below.
Jason Hall has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.