Individual retirement accounts, or IRAs, enable your money to grow tax-free and can be a major contributor to your retirement assets.
Perhaps you’ve already established an IRA for yourself. If not, contact a financial advisor or do research on your own to see how you can get started.
Christine Benz, director of personal finance at Morningstar, authored a report on 20 mistakes to avoid in dealing with your IRAs. Here are five of them.
- “Assuming Roth contributions are always best.” Benz notes that investors have heard so much about the virtues of Roth IRAs’ tax-free compounding and withdrawals, … that they might assume that funding a Roth instead of a traditional IRA is always the right answer.” But “it's not.” The money you put into a Roth IRA is taxed before the contribution. The money you put into a traditional IRA is taxed after you take it out. This isn’t from Benz, but a basic rule of thumb is that if you think your income-tax rate in retirement will be lower than it is now, you want a traditional IRA. And if you think your tax rate will be higher in retirement, you want a Roth IRA.
- Thinking of the choice between a Roth IRA and a traditional IRA "as an either/or decision.” “[If] you have no idea [what your tax bracket will be in retirement], it's reasonable to split the difference,” Benz said. “Invest half of your contribution in a traditional IRA and steer the other half to a Roth.”
- “Not contributing later in life” to an IRA. “Many Americans are working longer than they used to,” Benz noted. “Making Roth IRA contributions later in life can be particularly attractive for investors who don't expect to need the money in their own retirements but instead plan to pass it on to their heirs.” That’s because the heirs will be able to take withdrawals of those funds tax-free. Roth IRAs also are advantageous because they don't impose required minimum distributions, while traditional IRAs do, she said.
- “Delaying contributions because of short-term considerations.” Benz explains that “investors, especially younger ones, might put off making IRA contributions, assuming they'll be tying their money up until retirement.” But that’s not necessarily the case. “Roth IRA contributions are especially liquid and can be withdrawn at any time for any reason without taxes or penalty,” Benz said. “And investors may withdraw the investment-earnings component of their IRA without taxes or penalty under very specific circumstances.”
- “Thinking of an IRA as mad money.” Some investors do that, seeing the IRA money as "suitable for investing in niche investments such an exchange-traded fund [focusing on] electric vehicles or cryptocurrency,” Benz said. “Don't fall into that trap.” Core investment assets, such as diversified stock, bond, and balanced funds, make the most sense, Benz said.
