There are many IRA rules that you need to know, such as the fact that contributions must be made with earned money and that contributions for the 2014 tax year share the same deadline as your tax return -- April 15, not Dec. 31, as some might assume. But the rules imposed by the IRS are mere details compared to the ones you should impose on yourself.
Before I get to those, though, let's run through the basics of traditional and Roth IRAs. Both are tax-advantaged retirement savings accounts, and your IRA contributions can total up to $5,500 in 2014 -- plus an additional "catch-up" contribution of $1,000 if you're aged 50 or older.
With a traditional IRA, you contribute pre-tax money and thereby reduce your taxable income for the year. For example, if your taxable income is $60,000 and you contribute $6,000 to a traditional IRA, your taxable income drops to $54,000. If you're in the 25% tax bracket, you can avoid paying 25% on that $6,000, thereby saving $1,500 for the tax year. You will be taxed on your ultimate withdrawals, though, years down the road.
Meanwhile, Roth IRAs offer a tempting twist: You fund them with post-tax dollars, reaping no immediate tax benefit. But, if you play by the rules, you can withdraw money from the Roth IRA in retirement tax-free!
So what are the three critical IRA rules that you should apply to yourself? Read on.
First off, it's essential that you contribute to an IRA. According to a study by the folks at TIAA-CREF, only about 17% of adults are contributing to an IRA, down from 22% in 2012.
IRAs can really help you accumulate wealth for your retirement days. To give you an idea of just how powerful they can be, imagine that you contribute just $3,000 to one for 30 years and your assets in the account grow by an annual average of 8%. You'll end up with a whopping $367,000. That's a lot of money for such a modest annual contribution. If your investments only average annual growth of 5%, you'll still end up with more than $200,000. And if you manage to earn the stock market's long-term average of 10%, your account will swell to $540,000 -- more than half a million dollars!
If you don't have an IRA, you should get one as soon as possible and start contributing. You can set up an IRA account at many good brokerages or financial institutions.
Max it out
Let's go beyond the example above that shows you how much you can accumulate with a modest $3,000 annual contribution. Because, let's face it: Most of us will need to rely on ourselves for most of our retirement income, as Social Security won't fully support us, and few of us will have pensions. Further, many of us did not start saving and investing for retirement when we were young, so we need to make up for lost time.
So imagine socking away $5,500 annually for 30 years and earning an 8% average annual gain. You'll end up with $673,000. At growth rates of 5% and 10%, your account will grow to $384,000 and $995,000, respectively. Yes, you could build up a million dollars in three decades by investing a relatively modest investment of $5,500 per year, or about $460 per month.
Now here's the kicker: If you did all this investing in a traditional IRA, you would reduce your taxable income each year by that $5,500 -- a considerable sum. And better still, if you did it in a Roth IRA, that nest egg would eventually be yours to draw on tax-free. That can make a huge difference in retirement.
IRAs also offer a big advantage over 401(k)s in that you can invest in a huge array of stocks or funds with them, instead of the more limited menu offered by most 401(k)s. (However, if your employer offers 401(k) contribution matches, be sure to take full advantage of that.)
Don't short-change yourself when it comes to your retirement. Save aggressively for your golden years.
Finally, once you have an IRA and are contributing to it, be sure to invest those assets strategically. Remember, for example, that whatever you park in a Roth IRA can grow for many years and can be liquidated in the future tax-free. Thus, if you like to invest in relatively small companies that you think will skyrocket over the long run, consider investing in them via a Roth IRA.
Imagine, for example, that you bought into Apple 15 years ago in your Roth IRA, maxing out the allowable contribution for 1999 of $2,000. Apple stock has averaged annual gains of 27.5% over the past 15 years -- enough to turn a one-time investment of $2,000 into about $76,500. Thus your gain would be about $74,500 -- and if your tax rate for long-term capital gains was 15%, you'd be saving more than $11,000 in taxes by investing through a Roth IRA. (Of course, not every would-be highflyer pans out, which is why you should always diversify into a range of holdings.)
Other good candidates for Roth IRA investing include healthy and growing dividend-payers. Imagine, for example, that you invest in 100 shares of IBM, which recently offered an annual payout of $4.40 that translates into a 2.4% dividend yield. Well, IBM has hiked its payout by an annual average of about 20% during the past decade.
Let's assume you hold on to your shares for 20 years in a Roth IRA. Unless IBM falls on unexpectedly tough times, it should still be around, and it should have appreciated in value. Let's say its dividend is raised by 12% annually during those 20 years. If so, the payout per share would be $42.44, giving you more than $4,000 in annual income in your Roth IRA. Those dividend dollars will accumulate -- and can be reinvested within the account -- until you withdraw them. Best of all, in a Roth IRA, those dividends will all be tax-free.
With a traditional IRA, your withdrawals in retirement will be taxed at your ordinary income tax rate at the time. That may well be higher than the current 15% tax rate applied to long-term capital gains and dividends for most folks. Thus you might want to limit long-term stock holdings in a traditional IRA. If you're going to trade stocks frequently, though, a traditional IRA can be a good place to so, as you'll be sheltered from frequent taxes on short-term gains. Bonds can be good investments for traditional IRAs, too, as their interest is typically taxed at your income tax rate, which is often lower in retirement.
For most of us, IRAs offer tax advantages that can make a meaningful difference in our retirement savings. So keep the three rules above in mind.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and International Business Machines. 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.