An IRA is a fantastic retirement saving tool, but many Americans don't take advantage of it, and when they do, they fail to make the most of it. If you're among them, don't worry. Here are some rules to help you build a bigger nest egg with an IRA.
What are IRAs?
As a refresher, you can get big tax benefits by saving money for retirement in a traditional IRA or a Roth IRA.
In 2017, you can set aside up to $5,500 of your earnings in either a traditional IRA or a Roth IRA or a combination of the two. If you're 50 years old or older, then you can save up to $6,500 of your earnings in an IRA.
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Traditional IRAs can be funded with pre-tax money, which means that money you put in now isn't taxed at your current tax rate. Instead, that money, and any future gains, are taxed when its withdrawn. Because of this feature, traditional IRAs can make sense if you think your income tax rate in retirement will be lower than it is today.
Alternatively, Roth IRAs are funded with after-tax money, which means you're paying taxes on your contributions now so that you can withdraw them -- and future gains -- tax-free in retirement. Because of up-front taxation, a Roth IRA can make sense if you expect your income tax rate in retirement to be higher than it is today.
Some important IRA withdrawal rules
In the case of a traditional IRA, if you don't wait until you're at least 59.5 years old, the IRS will charge you income taxes on any money that you withdraw, plus a 10% penalty, unless you qualify for an early withdrawal exemption (more on that in a minute).
In the case of a Roth IRA, you can withdraw your contributions tax-free at any age without a penalty, as long as the Roth IRA has been established for at least five years. However, any gains that you withdraw prior to reaching age 59.5 can be subject to income tax and penalties.
Both traditional IRAs and Roth IRAs do allow penalty free, early withdrawals in specific instances. A full list of these exemptions can be found here, but the big ones to know about include purchasing a first home (up to $10,000), or paying college tuition for you, or an immediate relative, such as a spouse or child. The rules for taking advantage of these exemptions can be quite complex, so make sure you consult a tax professional before taking any early withdrawals. After all, the last thing you want is a surprise at tax time!
Overall, a Roth IRA might be a better option if you think you'll need to withdraw contributions five or more years from now, and you won't be 59.5 years old or qualify for an early withdrawal exemption at that time.
Navigating the IRA income caps
In order to qualify for a tax deduction on a traditional IRA contribution, your modified adjusted gross income has to be below set limits if you, or your spouse, are covered by a retirement plan at work. Similarly, in order to contribute to a Roth IRA, your modified adjusted gross income needs to be below set limits too.
Recently, fellow Motley Fool Matthew Frankel did a great job at explaining adjusted income limits for IRA's here, but in short, if you're single and you are covered by a retirement plan at work, you can take the full deduction on a traditional IRA contribution if your adjusted income is below $62,000 in 2017. You can qualify for a partial deduction if your adjusted income is between $62,000 and $72,000.
If you're single, you can make a contribution to a Roth IRA as long as your adjusted income is less than $118,000. You can make a partial contribution if your adjusted income is between $118,000 and $133,000.
If you're married filing jointly and covered by a retirement plan at work, then you can take a tax deduction on your traditional IRA contribution, as long as your adjusted income is below $99,000. A partial deduction is possible if your adjusted income is between $99,000 and $119,000.
If you're not covered by a plan at work but your spouse is, then you can make a tax deductible contribution to traditional IRA if your adjusted income is below $186,000 or a partial deduction if your adjusted income is between $186,000 and $196,000.
If you're married filing jointly, you can contribute to a Roth IRA as long as your adjusted income is below $184,000. A partial contribution can be made if your income is between $184,000 and $194,000.
If you think you're close to these limits and you're unsure of how to calculate your modified adjusted gross income, you can read up on the subject here.
How to invest in an IRA
Once you've contributed to an IRA, you'll need to pick some investments. There are a lot of choices, and you'll want to think carefully about your age, your health, and the number of years you have until you begin withdrawals.
If you're young, in good health, and have plenty of years to ride out the inevitable recession, then an IRA that includes stocks, stock ETFs, and stock mutual funds can make sense. Usually, buying and holding stocks and ETFs for long periods of time is cheaper than buying an actively managed mutual fund, so make sure that you balance the potential return, risk, and expenses associated with these choices.
Some investors may prefer owning individual stocks for the long term, such as disruptive growth companies like Amazon or Alphabet. Other investors may prefer owning an S&P 500 ETF that tracks the stock market's returns more closely. If so, a low-cost S&P 500 ETF that might fit the bill is the Vanguard S&P 500 ETF (VOO +0.18%). It has an annual expense ratio of just 0.05%.
It may also pay off to own dividend-paying stocks in an IRA. Because IRAs offer tax advantages, dividend payments can compound over time tax-deferred, or in the case of a Roth IRA, potentially tax-free. Historically, dividend-paying stocks have outperformed non-dividend-paying stocks. However, the performance of dividend stocks tends to be lower during periods of rising interest rates, when they have to compete with bonds for income investors' attention.
Overall, building a diversified IRA that includes exposure to stocks and stock ETFs can provide financial security in retirement. For example, if you're 30, and you contribute $5,500 per year for 35 years and earn a hypothetical 6% return per year, then you'll have a nest egg valued at $612,886 at age 65. That's not chump change, so make sure that you take advantage of this powerful savings tool.
