IRAs are a popular topic at tax time. Filling out tax forms encourages many people to consider opening an account or adding an existing one to either save on taxes now or later in life. While you may save on taxes with an individual retirement account, you should be knowledgeable about your options to ensure your decision works for you - now and in 20 years.
If you do not have an IRA already, odds are you know many people who do. More than $5.4 trillion was invested in individual retirement accounts in the U.S. as of 2012. Maximizing retirement investments for the best results (and returns) requires understanding what the accounts are, where you are investing, fees you are paying and tax ramifications of decisions now and decades down the road.
Tax now or later?
These individual retirement arrangements (which is technically the IRS name for what everyone else calls individual retirement accounts) gained popularity with the Economic Recovery Tax Act of 1981, which sought to encourage economic growth by reducing income tax rates with, among other things, incentives for saving. IRAs were promoted to allow people to save and invest on a pre-tax basis up to an annual IRS-determined limit. As many recent retirees can caution you, the taxman takes his cut on that money upon withdrawal. Fearing the inevitable tax hit led to the creation of Roth IRAs in the late 1990s. The Roth IRA involves saving on an after-tax basis with no federal taxes on earnings and withdrawals later on.
Accordingly, the first tax consideration to make is which type of IRA is best for your situation. There are IRS guidelines limiting participation, particularly for those with access to an employer plan. The risk or assumption you make when deciding which type of IRA is best for you is whether you are better off paying taxes now or later. This depends on your income level as well as unforeseeable changes in tax laws down the road. If you earn way less in retirement and taxes are lower overall, then waiting and a regular IRA makes sense. However, many people forget that the money they are withdrawing counts as income then (taking out $40,000 a year, whether in a regular IRA or 401(k), is earning $40,000, plus Social Security and other income). Conversely, paying high taxes now and saving in a Roth IRA assumes your investment earns a lot that will be withdrawn later federal tax-free.
Considerations for all IRAs
Those are the first taxing considerations to make. Here are other things to consider on your IRA and managing your retirement savings overall:
- Mixing types: IRAs were created for people to save on taxes, either now or later. However, you need to review your whole situation and possibly hedge your bet on tax levels in the future to understand if there are IRA tax benefits for you. If most of your retirement money is in traditional accounts or investments that will be taxed later (other IRAs, 401(k)s, stocks or real estate), using a Roth IRA to build some nontaxable retirement money can provide tax diversification later. Changes in tax laws regarding property tax and mortgage interest deductions may also muddy your picture going forward and make you consider a different retirement savings mix.
- Age rules: Two other considerations are age related - what happens is the money is needed before turning 59½, and how rules change at age 70½.
- While the plan should be to not touch the money until you are older, a job loss, unexpected financial drain or educational expenses may require pulling some of it out earlier. The IRS imposes a 10 percent penalty, in addition to tax on the dollars as income, on distributions taken before reaching age 59½, but there are exceptions allowed for things like disability, reservists called to active duty, health insurance costs for the unemployed, some early retirees and higher education expenses.
- In the tax year you turn age 70½, you must begin taking required minimum distributions from pre-tax plans. The required minimum distribution for any given year is based on the account balance at the preceding year-end divided by a distribution period from the IRS's "Uniform Lifetime Table." The penalty for not taking the taxable money is forfeiting half of it. Yes, there is a 50 percent excise tax on amounts not taken as required each year. (There is no similar requirement on Roth IRAs.)
- Investment or market risks: The top risk most people think of on investments is market risk. Whether the monies are tied up in stocks, bonds, mutual funds, ETFs or a well-balanced assortment, they are subject to market risk. The value can fluctuate because of new legislation, economic news, natural or man-made disaster or some other unforeseeable change in the global or regional economy. The best protection against market volatility is having a diverse portfolio spread between types of investments, varying asset classes, geographic or economic sectors, value versus growth and, on the bond side, varying types and durations. This blend - and balancing it periodically - can be daunting. Some people opt for index or age-based funds to minimize the effort, but a professionally managed IRA can also be a great option to protect from market risk. While some actively managed IRAs have higher fees that cut into returns, GuidedChoice offers a managed IRA that is priced far lower than other options.
- Liquidity risks: This is essentially the ultimate market risk - not being able to quickly sell or cash in your investment holding when you need the funds. To mitigate this, some people take set distributions at periodic intervals. However, that forces sales when values are low, thereby locking in losses. To protect against liquidity issues, it helps to have cash or money market account balance to draw upon if needed and a balanced selection of assets to liquidate. Another strategy is purchasing annuities or guaranteed-return investments to ensure a steady income stream so liquidity and timing are not issues. For those near retirement age (or even already there), consider a Retirement Income Planning Service to develop an optimal spending and withdrawal plan.
- Fraud risks: There are three main fraud concerns to be wary of: A "fiduciary" looking after their own interests, not yours, in dealing with your account. Identity theft whereby someone gains illicit access to your account and its assets. Cognitive decline in the future could impact your ability to make sound decisions in your own interest. Educating yourself and establishing a relationship now with a trusted adviser can help establish, manage and protect your funds for the foreseeable future. Opting for an independent partner as a fiduciary, like GuidedChoice, helps ensure there are no affiliations tied to or incentives earned for recommending an investment.
- Missed deadlines: There are some key dates and deadlines that affect taxes on IRAs:
- You must contribute by April 15 to deduct against income for the prior year. However, since April 15, 2018, is on a weekend, the deadline for 2018 is April 17.
- The deadline to convert a traditional IRA to a Roth version is Dec. 31; in other words, the move must be done during the tax year involved.
- You can only contribute to a traditional IRA up to age 70½ and must start taking withdrawals that tax year. For example, if you turn 70 on June 30, you reach age 70½ that December, so you must take your initial required minimum distribution for that year by April 1 of the following year (the deadline is before you file your taxes for that reason). If your birthday was one month later and you did not reach 70½ until January, you have an additional year before a distribution is required.
Multimillions of Americans have IRAs, but the accounts are actually more complex than many realize. You need to carefully weigh the tax ramifications, the effect of the latest tax changes, and your timing on your retirement savings options to determine what kind of account and how it should be invested. If you are planning to open or add to an existing IRA before the April deadline, you may want to talk with an expert on retirement income planning and whether or not IRA tax benefits can be leveraged for your future. GuidedChoice and its staff have been advising people on retirement savings for decades. They can help you better understand your options, risks, associated fees and tax situation. If you need help determining what IRA is best for you, our free concierge service can help you select the right IRA for you, even if it isn't with us. Book an appointment now.