It’s been a few weeks since the close of 2015, but it’s not too late to save money on your taxes and boost your retirement savings while you’re at it.
The IRS allows you to put money aside in an IRA through April 15, as long as you specify that the contribution is for the 2015 tax year. Although it doesn’t carry the same immediate benefits for your IRS filing, the contribution period for putting after-tax money into a Roth IRA also extends through April.
IRAs are a great savings vehicle for millions of Americans, particularly for those who don’t have access to a 401(k) at work or whose employer-sponsored 401(k) has high fees or lousy options. They’re also a place for those lucky folks who are maxing out their 401(k)s to stash additional tax-sheltered money.
Planners love IRAs — especially Roths — for their flexibility and tax perks, but Americans consumers are less enamored. Just 8 percent of those surveyed by TIAA-CREF last year said that contributing to an IRA was their first financial priority, one-third the number who said that saving for things like vacations and household appliances topped their list.
Nearly 40 percent of those surveyed said that they weren’t contributing to an IRA because they didn’t know enough about the accounts to consider one. If you’re among those who could use a refresher, read on to learn what you need to know about IRAs:
1. They’re easy to open. You can set up a Roth or a traditional IRA with just about any bank, brokerage or mutual fund company. The two accounts share contribution limits (currently $5,500 for younger savers, $6,500 for those over age 50), though there are some key differences in the two accounts, which we’ll detail below.
2. The tax implications depend on the type of account. You’ll pay taxes now on any money contributed to a Roth, but the money then grows tax-free and you won’t owe any taxes on qualified withdrawals. “For most people, the Roth will give you more spendable income in retirement,” says Stuart Ritter, a senior financial planning analyst at T. Rowe Price. “The exception is if you think that your tax bracket is going to go down significantly in retirement.”
In a traditional IRA, your withdrawals will be taxed, but you may be able to deduct your contributions. If you have a retirement plan at work, deductible contributions phase out for individuals making between $61,000 and $71,000 and for joint filers earning between $98,000 and $118,000.
3. Roth IRAs have an income limit, but there’s no age cut off. Roth IRA contribution limits phase in for individuals making between $116,000 to $131,000 and for married couples making between $183,000 and $193,000. Savers earning more than that will have to stick with a traditional IRA. It is possible to convert a traditional IRA to a Roth, but the rules get complicated so consult a CPA or financial advisor.
There’s no age limit for contributing to a Roth IRA, but savers over age 70.5 can no longer put money into a traditional IRA.
4. Roths offer more flexibility on withdrawals. While they’re intended as retirement accounts, you can withdraw contributions (but not earnings) to a Roth at any time penalty-free. That flexibility makes Roth IRAs a good option for new savers who haven’t yet amassed both an emergency savings account and a retirement account. Since withdrawals can be made at anytime, the Roth can serve as both saving for retirement and emergencies until you’re able to designate funds specifically for the latter.
“The problem then is that it can then become tempting to take money out of your retirement account,” says Ed Slott, author of the retirement-planning books Fund Your Future: A Tax-Smart Savings Plan in Your 20s and 30s and The Retirement Savings Time Bomb … and Hot to Defuse It. “Hopefully you won’t touch it, but if you have to, you know that you can.”
Making pre-retirement (before age 59.5) withdrawals on a traditional IRA typically results in a 10 percent tax penalty. After age 70.5, however, you’ll have to start taking required minimum distribution, or RMD, each year, and paying taxes on them. Failing to take the required minimum withdrawal (which is calculated based on your life expectancy and account balance) results in a penalty of 50 percent of the amount you failed to withdraw.
5. You can contribute even if you have a 401(k). More than 80 percent of households with an IRA in 2014 also had some sort of workplace retirement plan, according to the Investment Company Institute.
You may not be able to deduct your contributions if you have a workplace retirement plan, but it may still be worth putting money in an IRA to get additional tax-deferred earnings. Since you decide where and how to invest your money, IRAs have far more options than 401(k)s and can be a good way to round out a portfolio with investments you may not have access to via your workplace plan.
6. You need to put the money to work. In your haste to meet the tax deadline, you might be tempted to park last-minute IRA contributions in a money-market fund. That’s a common move, but two-thirds of investors who put money into a money-market fund during tax season hadn’t invested the cash four months later, according to a 2014 Vanguard report. “What seems like prudent temporary decision can become an ill-advised longer-term investment choice,” the report states, advising investors instead to make a target-date fund, which adjusts its investment mix based on your age, their default investment option.
7. They’re a great place to stash old 401(k) money. If you took a new job last year and are unimpressed with the investment options in either your old 401(k) or the one offered by your new employer, you can take the money from your former plan and put it into an IRA of your choosing. Last year, more than half of affluent investors planned to roll their 401(k) money into an IRA, according to a study by Cogent Reports.
Now that you’ve got the basics, remember — you have until April 15 to make your 2015 contribution. If you have other questions about IRAs and how they work, email us at AskTFT@thefiscaltimes.com. Your questions could be used in a future article.