Retiring on Social Security alone is a seriously bad idea. With the average retired worker today only getting about $23,000 in annual benefits, it's just not enough money to live on -- or at least not comfortably.
That's why it's so important to save for retirement on your own. And to that end, you have choices.
If your employer offers a 401(k) plan, you may be inclined to sign up. But 401(k)s can seriously limit your investment choices. And if your company doesn't provide one -- well, you're out of luck.
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The good news is that anyone with earned income can contribute to an IRA. So you may decide to make an IRA your go-to retirement savings plan. But here are some snags you might hit if you stick with an IRA.
1. You'll face taxes on withdrawals in retirement
Unless you keep your money in a Roth IRA, your retirement plan withdrawals will be subject to taxes during your senior years. You may think that's no big deal since you're used to the IRS taking a portion of your income.
But remember, come retirement, you may be adjusting to living on less. To then have to lose some of that income to taxes might be a blow. So if you're going to use an IRA to build a nest egg, consider keeping at least some of your savings in a Roth.
2. You'll be subject to RMDs
Traditional IRAs eventually force you to remove a portion of your savings balance each year in the form of required minimum distributions (RMDs). These can then create an unwanted tax liability for you and make it harder to pass your IRA on to your heirs if that's something you want to do.
Once again, a Roth IRA could come to the rescue. Roth IRAs don't impose RMDs, which means your money can sit and grow in a tax-advantaged manner indefinitely.
3. You're limited in what you can save
IRAs max out at $7,000 this year for workers under 50 and $8,000 for those 50 and over. This holds true for both the traditional version and the Roth.
You can absolutely build a solid nest by contributing $7,000 or $8,000 per year toward retirement over time. But you'll probably need a fair amount of time if you're limited to these contributions. So if you're first starting to save for retirement in your 40s or 50s, you may need to look beyond just an IRA.
One option that could work is a health savings account (HSA), if your health plan is eligible. HSA funds never expire, so you can carry a balance into retirement and use it for your healthcare needs. HSAs also give you penalty-free access to your balance starting at age 65, which allows these plans to double as general retirement accounts.
4. You could end up with a penalty if you retire early and want to get your money out
The IRS offers some pretty sweet tax breaks for IRA savers. In return, the IRS wants you to leave your money alone until you reach an appropriate retirement age, which its definition is 59 1/2. If you pull money out of your IRA beforehand, you'll generally face a 10% early-withdrawal penalty.
That could be a huge problem if you end up retiring at a younger age than that. For example, it's not like retiring at age 55 is unreasonable if you've saved enough money so you're comfortable doing so. But you may not want to lose some of your savings to a penalty.
For this reason, it's a good idea to combine IRA contributions with a traditional brokerage account. Maxing out your IRA before moving on to a taxable investment account is generally best. But aim to keep part of your nest egg in an account that isn't restrictive and doesn't impose penalties for taking money out at a certain age.
There's nothing wrong with saving for retirement in an IRA, as long as you understand the pitfalls and are able to work around them. Branching out to different accounts and leaning on a Roth to at least some degree could help you avoid some of the major problems IRA savers tend to face.
