There are lots of good reasons to save for retirement with a traditional IRA. Not only will your contributions be tax-deductible, but your earnings will get tax-deferred treatment from the day you open your account up until retirement. That said, it pays to be careful with your IRA, because a few negligent moves could end up costing you in the long run. Here are three in particular to avoid.
1. Taking early withdrawals
The tax benefits offered by IRAs are what prompt so many workers to fund their own accounts. But in exchange for those tax breaks, you're expected to leave that money in place until you actually retire. In fact, if you attempt to get at that money before reaching age 59 1/2, you'll not only pay taxes on your withdrawal, but face a penalty equal to 10% of the amount you remove prematurely.
Now there are a few exceptions to this rule. You can, for example, withdraw IRA funds early to pay for college, or take up to a $10,000 withdrawal to purchase a first-time home. But if you take an early distribution because you want or need the money for most other purposes, you'll lose 10% of that lump sum right off the bat.
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That penalty, however, isn't the only reason to avoid an early withdrawal. Simply put, if you remove money from your IRA during your working years, the amount you withdraw won't be available to you in retirement. And given that most Americans are behind on savings, that missing distribution could come back to bite you down the line.
Also remember that when you remove money from an IRA, you're not just losing out on that principal sum; you're also missing the opportunity to invest and grow that money. Imagine your investments typically generate an average yearly 7% return, which is a few points below the stock market's average. If you take a $20,000 withdrawal at age 45 to buy a new car, and retire 20 years later, you won't just have $20,000 less in your IRA; you'll be $77,000 short when you consider the growth opportunity you ultimately missed out on. And that kind of money is bound to make a huge difference when you're retired and living on a fixed income.
2. Forgetting about required minimum distributions
The money in your traditional IRA can't just sit there indefinitely. Rather, you're required to start withdrawing a portion of your account once you turn 70 1/2. The amount of your required minimum distribution (RMD) will depend on your life expectancy and account balance at the time, but if you fail to remove the amount you're supposed to, you'll face a 50% penalty on however much of that distribution gets left in your account. So if, for example, your RMD for the year is $8,000, and you only take $4,000 out of your account, you'll lose 50% of that remaining $4,000, or $2,000 -- just like that.
Now for some people, RMDs aren't a huge concern because they're already making consistent withdrawals by the time they reach 70 1/2. But if you're not in the habit of taking distributions, you'll need to pay attention to RMD deadlines to avoid losing out. Keep in mind that RMDs apply even if you're still working full-time. Furthermore, because those withdrawals are taxable, you'll need to plan carefully to avoid a whopping bill from the IRS.
3. Starting too late
Unlike traditional brokerage accounts, IRA earnings aren't taxed year after year. This means that any time you make money, you can reinvest it and grow it further. It's a concept known as compounding, and it's what allows so many savers to become millionaires by investing just a few thousand dollars each year.
To best take advantage of compounding, however, you'll need to give your money ample time to grow -- which means that if you hold off on funding your IRA for too many years, you'll lose out on a huge chunk of money that could otherwise come in handy during retirement.
The following table shows what your IRA can grow to depending on when you first start saving:
|
If You Start Saving $450 a Month at Age... |
Here's What You'll Have by Age 65 (Assumes a 7% Average Annual Return)... |
|---|---|
|
25 |
$1.078 million |
|
30 |
$746,000 |
|
35 |
$510,000 |
|
40 |
$341,000 |
|
45 |
$221,000 |
Calculations by author.
Let's dive into these numbers a bit. First, you should know that the current annual IRA contribution limits are $5,550 for workers under 50, and $6,500 for those 50 and older. The above table assumes a monthly contribution of $450, which is just below the point of maxing out under the present threshold for younger workers.
Now as you can see, if you give yourself a 40-year savings window, you'll eventually have more than $1 million to your name at a cost of just $216,000 out-of-pocket. That's because if you start early and keep reinvesting your earnings, you'll make money not just on your principal contributions, but on your gains as well.
But watch what happens when you narrow that savings window to just 20 years. Though $221,000 is a pretty respectable sum, it's nowhere near the $1.078 million you'd have by starting two decades earlier. And while that $221,000 will only cost you $108,000 in out-of-pocket contributions, representing a $113,000 gain, it's not even close to the $862,000 gain you'd be sitting on by kicking off your savings efforts at 25. Challenging as it may be to part with a portion of your income and set it aside for the future, the sooner you start funding your IRA, the more cash you'll have available when you're older and need it the most.
The more you read up on IRA rules, the greater your chances of avoiding mistakes that could very well come back to bite you. If you stay away from early withdrawals, pay attention to RMDs, and start saving as early on in your career as possible, you'll be in the best position to make the most of your IRA.
