An IRA can be an excellent way to save money for your retirement, and it can also cut your tax bill. However, it's important to make sure you're taking full advantage of your IRA by choosing the right type of account, buying the right kind of stocks, contributing as much as possible, and staying the course. Here's how to do these things, and why they are so important to your investing success.
1. Decide if a traditional or Roth IRA is best for you
The first step to maxing out your IRA is to make sure you choose the right one. While there are a few specialized types of IRAs for small-business owners and the self-employed, for most people the choice is between a traditional and Roth IRA.
By far, the biggest difference between the two is the tax treatment. Contributions made to a traditional IRA may be deductible on your tax return, but your withdrawals in retirement will be treated as taxable income. Roth IRAs work the opposite way -- contributions aren't deductible, but qualifying withdrawals will be 100% tax-free. In both cases, investments are allowed to grow on a tax-deferred basis, meaning no dividend or capital gains taxes each year.
So, if you are in a relatively high tax bracket now and could benefit from an immediate deduction, a traditional IRA could be your best bet (just make sure you qualify for the deduction). On the other hand, if you're in a low tax bracket like most people are early in their careers, a Roth IRA can effectively "lock in" your lower tax rate.
Of course, there are some other differences to think about. For example, you'll be required to start withdrawing from a traditional IRA at age 70-1/2, while a Roth IRA has no such requirement. Here's a thorough discussion of the differences that can help you choose the best IRA.
2. Take full advantage of your IRA's tax benefits
Your IRA lets your investments grow on a tax-deferred basis, so make sure you take advantage of this by filling it with the right kind of stocks. Specifically, your high-dividend investments should be kept in an IRA in order to maximize their compounding power.
As a simplified example, if you invest $5,000 in a stock that pays a 5% dividend in your Roth IRA, your investment will compound to just over $28,000 after 20 years, assuming the stock price goes up by 4% per year (average total return of 9% per year). If you are in one of the tax brackets in which qualified dividends are taxed at 15%, and you hold the same stock in a taxable brokerage account, that dividend yield will effectively be reduced to 4.25%, or an annualized total return of 8.25%, which would limit the investment's 20-year growth to $24,400.
On the other hand, holding a stock that doesn't pay a dividend is effectively the same thing in either type of account. Of course, you'll have to pay capital gains tax on any investment profits made in a standard brokerage account, so if you can fit all of your stocks in your IRA while staying under the contribution limits, do it. However, if you can't, it's important to allocate your investments wisely. As a personal example, my taxable brokerage account has stocks like Alphabet and Berkshire Hathaway in it, with the bulk of my dividend payers like REITs in tax-advantaged accounts.
3. Max out your contributions
It may sound obvious, but the best way to increase your IRA's compounding power is to contribute as much as possible. For the 2016 tax year, you can contribute up to $5,500 to your IRA ($6,500 if you're over 50), which translates to about $458 on a monthly basis.
Consider this: If you contribute $5,500 to an IRA each year for 30 years, your account's value could balloon to more than $820,000 if your investments appreciate at the stock market's historical average.
Now, I completely understand that it may not be practical for many people to contribute the absolute maximum allowed to your IRA. If you have a good 401(k) and contribute a large amount to it, maxing out your IRA may not be necessary, either. However, even a small increase in your contribution rate can mean thousands of dollars in additional retirement savings later on.
4. Don't overtrade -- be patient
Once you've filled your IRA with high-quality stocks, the best advice I can give is to leave them alone.
Now, there are plenty of good reasons to sell a stock. If your original reasons for buying it no longer apply -- growth slows down or the company's competitive advantage disappears, for instance -- it's completely acceptable to sell. In fact, even Warren Buffett, who many regard as the best buy-and-hold investor of all time, sells stocks from time to time.
However, it's extremely important not to overtrade. Unfortunately, it is human nature to sell at the worst possible times (during market crashes) and buy when the market gets expensive. Emotional trading like this is the primary reason the average investor dramatically underperforms the market. In fact, according to BlackRock and Dalbar, the stock market produced an annualized 8.19% return during the 20-year period from 1996 through 2015, while the average investor only managed an annualized return of 2.11% during that time, not even enough to keep up with inflation.
5. Get started today
As a final tip, the best thing you can do is get started (or boost your contributions) as soon as possible. Your biggest advantage when investing is time, and this is especially true when we're talking about the tax-advantaged compounding power of an IRA. If you're 30 years old, every $1,000 you invest today could be worth nearly $24,000 by the time you turn 65, based on the stock market's historical returns.
The bottom line is that your time advantage is never going to get any better than it is right now, so apply some of the suggestions I've discussed here and get started now.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Matthew Frankel owns shares of Alphabet (C shares) and Berkshire Hathaway (B Shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Berkshire Hathaway (B Shares). 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.