The Internal Revenue Service (IRS) means business. The federal agency tasked with collecting taxes has spent decades honing and fine tuning their rules. These include the rules around contributions to savings vehicles such as an Individual Retirement Account (IRA). If you follow the rules, you could be on a path to a sound retirement with financial security. Run afoul of the rules, however, and it could put you on the road to personal ruin.
Those who make mistakes with their retirement accounts often learn the hard way just how costly they are. Even innocent mistakes can prove disastrous when it comes to retirement savings. Here are several mistakes to avoid when it comes to your IRA account.
Not Contributing Enough
Each year, the IRS sets a limit on the amount you can contribute to an IRA account. The 2020 limit is $6,000, or $7,000 if you’re over age 50. To receive the maximum benefit from your retirement account — the biggest possible nest egg, grown through investments — you should try to put the maximum amount into your account each and every year.
With a traditional IRA, you contribute pre-tax dollars to your account. You can then deduct those contributions from your taxes. However, when you eventually retire and begin withdrawals from your IRA, the money withdrawn is taxed as income. With a Roth IRA, your contributions get no tax breaks, but any eventual withdrawals made are tax-free. Regardless of whether you have a traditional IRA or Roth IRA, you should aim to contribute the maximum amount each year to reap the greatest rewards. Or at least as close to the maximum as you can afford.
Contributing Too Much
On the flip side, you can also make the mistake of over contributing to your IRA. Funding an IRA requires some precision. You’ll want to contribute the maximum amount each year, while still avoiding going over the limit. Should you exceed the contribution limit, the IRS will swiftly charge you a 6% penalty tax on the excess amount for each year that it remains in your IRA.
To rectify an over contribution, you must withdraw the excess money outright or reduce your future contributions until you are back on (or below) the contribution limit. While the 6% penalty may not sound like a lot, it can add up quickly. It will prove costly, depending how much money you have saved.
Withdrawing Funds Early
Withdrawing money from your IRA early is never advisable. The penalties for doing so are steep. By “early,” we mean before you are age 59 and a half. If you take money out before then – whether from a Roth IRA or a traditional IRA – and you’ll owe tax on it, plus a 10% penalty. That is a tough pill for anyone to swallow.
If you need money, your IRA should be the last place you look. Unless you are in dire financial straits through a job loss or serious illness, you should never take money from an IRA. You definitely shouldn’t use it to buy a car, a new TV, or a jet ski. While there are some exceptions to the early withdrawal penalties, such as if you are disabled or incur high medical expenses, these exceptions are too infrequent to warrant serious consideration. Keep your money where it is sheltered and safe – inside the IRA.
Not Investing The Money
An IRA is not a savings account. It’s not really a bank account at all. It’s more like an investment vehicle. We mention this because a shocking amount of people continue to treat their IRA like it is a standard savings account, where they simply store spare cash.
In reality, an IRA can hold an array of investments. The money can grow in mutual funds, stocks, bonds or exchange traded funds. Believe it or not, you can even hold real estate investments in an IRA. The purpose of an IRA is to invest the money, shelter it from taxes, and allow it to grow and earn interest. The worst thing you can do with an IRA is to simply hold cash in the account.
It’s important to take advantage of the investment and growth potential of an IRA. That means investing the money. Be sure to invest the funds in your IRA for maximum value. The best bet is a diverse array of investments, that you regularly check in on. But for goodness sake, do not just leave cash in your IRA. For that, you can get a traditional savings account at a bank.
Not Understanding How a Spousal IRA Works
The IRS is surprisingly generous when it comes to IRAs and spouses. Many people wrongly assume that you must be actively working to contribute to an IRA. If you aren’t earning an income, you can’t contribute to an IRA, right? That assumption is wrong.
A spouse who is not working (or staying choosing to stay at home to raise children) can still contribute to an IRA through what is known as a “spousal IRA.” The partner who is working can put money into a spousal IRA, up to a set annual limit. They can still also contribute to their own IRA, of course. The IRS established spousal IRAs so that you can maximize your retirement savings even if one person isn’t earning a regular income. Failing to take advantage of a spousal IRA is a huge missed opportunity. It basically allows you to save more as a couple than you would as an individual. That’s important if you plan to retire together someday.
Failing to Name a Beneficiary
One of the biggest mistakes you can make with an IRA is failing to name a beneficiary. After all, what will happen to your money if something happens to you? If you fail to designate a beneficiary, your heirs could face delays and possibly a court battle (not to mention a tax levy) in order to get their hands on the money.
If you have already named a beneficiary, good for you. Now be sure to keep the information up to date — especially after any major life changes. Don’t assume that a divorce, for example, will keep your ex-spouse from getting the money. An ex-spouse can still inherit the account unless you’ve gone in and removed their name and updated the account. Keeping the beneficiary information current and accurate will give you peace of mind. And it will make sure your savings go to the proper people if you pass away before you get a chance to use them yourself.
The Last Word
IRAs can be a great way to save for a secure and rewarding retirement. The key to success is understanding exactly how IRAs work and the rules that govern them. Knowing how much money you can contribute each year and investing those funds strategically is critically important. Mistakes made with an IRA can be costly and put you in the taxation doghouse. As always, knowledge is power. The more you know about IRAs, the better positioned you’ll be to take advantage of their many benefits. Happy savings!