The calendar year is almost over, and if you’re saving for retirement with an IRA, there are several smart moves you can make before the end of 2019.
Contribute the maximum amount
For the first time since 2013, the cap on the annual contribution to a traditional IRA has been increased $500 to a maximum of $6,000 for contributors younger than 50. Those age 50 and older are allowed to contribute an additional $1,000 as a “catch up,” bringing their total allowable IRA contribution to $7,000.
To contribute to an IRA, you must have earned income from work, and you cannot contribute more to an IRA than you earned. IRA contributions in 2019 are tax-deductible, and if you or your spouse do not have a 401(k) or other work retirement account, you can deduct your entire 2019 IRA contribution on your tax return. Make your 2019 contribution before the next tax filing deadline passes on April 15, 2020.
If required, take your minimum distribution
If you are age 70 ½ or older, you typically are required to take a minimum distribution, or RMD, from your IRA. Figuring out the amount of your RMD, however, can be difficult, and it’s best to go over your retirement account with a financial expert before taking any distributions (errors can be expensive). The amount of your distribution depends on your life expectancy and how much your IRA is worth – the IRS calculates it by dividing your IRA balance on the last day of 2018 by your life expectancy or the applicable distribution period.
You’ll be penalized 50 percent if you miss your RMD, a significant penalty for a retirement account. If you don’t need the money from an RMD but have to take it, you can donate the disbursement to a charitable cause through a qualified charitable distribution (QCD). In this case, the donation will go straight from your IRA to a qualified charity of your choice, and it will not be counted as personal income. QCDs are limited to $100,000 each year.
Review your assets
December is a great time for a year-end review of your investment policy statement (IPS). This document lays out how much of your money should be in cash, bonds, and stock, and when each category will rebalance. At the end of the year, you can evaluate whether your investments match the allocations on your IPS. If they don’t, which is likely, you may want to rebalance your account.
Financial experts recommend creating an IPS before the end of the year if you don’t have one. While it’s ideal to create your IPS in a calm market, if that’s not possible, make one right away, no matter the market conditions.
Avoid taxes on distributions
One significant downside of a traditional IRA is that distributions can be taxed and converting to a Roth account can eliminate some of these potential losses. Also, investors who donate their RMD to a qualifying charity or use the disbursement to buy a qualifying longevity annuity contract also can avoid disbursement taxes.
Converting to a Roth IRA may be an especially wise choice in years when your taxable income is low. The taxes you pay in a slow year will set a baseline for you to make good choices when your taxes could be higher. Investors between ages 59 ½ and 70 ½ likely won’t benefit from a Roth IRA conversion, however, as they aren’t required to take RMDs.
If you inherited a traditional IRA in 2019, you must take the RMD by the end of 2019 and pay the taxes on it – even if you are younger than 70 ½.
Don’t overdo it
While saving for retirement is generally encouraged, can you contribute too much to an IRA? Yes, and there are consequences. For example, if your income is better than usual for one year, and you make a large contribution to your IRA, you may have to pay a 6 percent penalty on your extra contributions until you fix the error. If you have over-contributed, there are remedies:
- Withdraw the excess contributions before April 15, 2020.
- If your tax return already is on its way to the IRS, you can remove the extra contribution and send in an amended tax return by the deadline in October.
- If you apply the extra contribution amount to 2020, you will still have to pay the 6 percent penalty on it for 2019, but you’ll get a “head start” on next year’s contribution.
While these are fixes, the best approach is to not make excess contributions at all.
Looking forward, IRA contribution rules will not change in 2020 – the maximums will remain at $6,000 and $7,000, depending on your age, for combined contributions to Roth and traditional IRAs. The window for 2020 contributions begins Jan. 1 and ends April 15, 2021.
The two basic types of retirement accounts are the 401(k) and the individual retirement account (IRA). While it is easy to confuse the two, they are actually quite different. While a 401(k) is an employee-sponsored account, anyone can open an IRA. This makes it an important product for people who do not have access to a 401(k) or who have already maxed out contributions to that account.
Unfortunately, the contribution limits for an IRA are significantly less than for a 401(k). However, they remain extremely important vehicles for retirement savings because of their tax advantages. An IRA is a way for the government to incentivize retirement savings outside of the employee-sponsored account.
The Various IRA Options Available Today
To open an IRA, individuals only need income from a job that is claimed for tax purposes, which rules out income from Social Security or an investment. When opening an IRA, individuals need to choose between a traditional and a Roth account. Like a 401(k), an IRA comes with certain tax benefits.
With a traditional account, individuals can contribute to the IRA and avoid paying any taxes on those contributions. However, when money is withdrawn from the account, it is taxed at that time. A Roth account involves investment of taxed income. Later, withdrawals can be made without paying any taxes, provided that individuals do not touch the account until they are at least 59.5 years old.
Some forms of specialty IRAs exist. For example, a simplified employee pension (SEP) IRA is geared for small-business owners and self-employed individuals. These accounts operate much like other IRAs except that they have much higher contribution limits.
Small-business owners are required to contribute the same rate to eligible employee accounts and their own. In other words, if the owner saves 10 percent of compensation, 10 percent of an employee’s compensation must also be saved. Employees cannot contribute directly to their own SEP IRA.
Another product is the Savings Incentive Match Plan for Employees (SIMPLE) IRA. This product is designed for companies with 100 or fewer employees. A SIMPLE IRA is easy to set up and allows employees to contribute to their own accounts.
Questions to Think about When Opening an IRA
Individuals can open IRAs through most financial service providers, from banks and credit unions to brokerage firms. Different service providers offer various advantages and disadvantages, so it is important to do some homework before opening an account.
Ideally, the financial institution provides individuals with a wide range of resources, from online education materials to in-person meetings, to help guide choices. These resources can help individuals plan for the future. Also, different providers will charge different types of fees. While some companies charge monthly fees, others have customers pay per trade.
Sometimes, companies will charge both monthly and trading fees, so it is important to understand the full payment scheme. Otherwise, individuals may end up paying a lot more for the service than they originally intend. It is also important to figure out what types of investments can be held in the account.
The point of opening an IRA is to invest money for retirement and have it grow over time. As a result, the exact investment options tend to matter quite a bit—especially for people who like to play an active role in investing decisions. People who prefer a more passive approach to investing should consider the possibility that they may want to get more actively involved in the future.
The Basics of Investing in an IRA
When it comes to investing money through an IRA, people need to consider the tradeoff between risk and return. An IRA should be viewed as a long-term investment. Generally, individuals will use an IRA to invest in stocks, especially if they are more than a decade away from retirement.
The stock market involves more risk, but it also usually yields higher returns than products like a certificate of deposit or a Treasury bond. While it is highly unlikely to lose money with these safe investments, individuals will also not earn much money. Different service providers may have some guidance to offer about how to navigate the creation of an effective portfolio. However, it is important that customers not feel pressured.
Alternately, individuals may want to take a fairly hands-off approach to investing in an IRA. In these cases, they may choose something like a total market index fund, which provides access to the kind of diversity needed to mitigate much of the risk involved in the stock market. These funds choose investments from a range of different geographic locations and across a number of different industries.
Individuals would struggle to obtain such diversification alone, even if investing very large sums of money. This option is for people who are willing to leave their money in accounts for long-term gains without the need to micromanage it. Another option for people who prefer a hands-off approach is a robo-advisor. This service will select investments based on the investor’s preferred cost and risk profile.
Nowadays, the majority of workers do not have a traditional pension that they can depend on for income once they retire. As a result, saving through a 401(k) has become more important than ever. However, maximizing your savings through this vehicle is not always as simple as it seems. You will need to pay close attention to the rules governing deposits into your account, as well as current tax policy. Otherwise, you may end up costing yourself money down the line.
Importantly, rules and policies change every year, so it is imperative that you pay close attention as you continue to save for retirement. However, there are some general tips that you should follow to maximize your savings:
1. Avoid fees
When choosing your 401(k) provider through your work, you should opt for one with the lowest or fewest amount of fees. While fees may not sound like much, they can add up quickly and significantly cut into the account value down the line, especially when accounting for compounding over time. Of course, the plan should also have the right risk tolerance. You should never feel like you have been cornered into a particular plan because of fees. If that happens, it is time to talk to human resources and consider an alternate savings plan, such as an IRA. Taking advantage of employee matches may still make sense, but once that is maxed out, another product may prove to be the best choice.
2. Diversify savings
When it comes to investing for the future, diversification is important—but many people do not understand how to do so. Diversification reduces your portfolio’s risk by making it more stable during market volatility or downturns. Financial planners recommend choosing both stocks and bonds to provide some degree of balance, as well as periodically rebalancing the portfolio to target allocations.
For example, individuals may rebalance their portfolio to reduce their investment risk as they get closer to retirement to protect the stability of their overall investment. One piece of advice that all financial planners agree with is that investors should never make impulsive changes to their risk profiles without consultation and great need.
Diversification may also mean investing in more than one 401(k) product. A Roth account can offer several benefits to people who max out their contributions to a traditional account.
3. Get matched
Perhaps the most important aspect of maximizing 401(k) savings is taking advantage of employer matching programs. Most often, employers offer 50 cents on every dollar from the employee, up to 6 percent of total pay (although the policies differ between companies). You should know exactly what your company will match and plan to take full advantage of the program. After all, matching is basically free money in your account. This matching program is an easy way to significantly boost your account and provide a larger base for further compounding in the future.
4. Get vested
Importantly, companies also have different policies on getting vested, which means that employees who leave the company too early may not get their 401(k) contributions matched. At some companies, getting vested takes as long as five or six years of service. While some will not pay out at all until an employee becomes vested, other companies will allow employees to keep a portion of their matched contributions when they leave early.
Often, becoming vested means thousands of dollars directly to the retirement fund, so it makes sense to stay as long as possible. However, you should never let the promise of getting vested drive you to stay in a bad job.
5. Rollover balances
When people do switch jobs, they have the opportunity to cash out their 401(k) plan—this is rarely a good idea. Before the age of 59 1/2, you will face a 10 percent early withdrawal penalty and you will be required to pay income tax on the balance. This can be problematic even if you want to reinvest your money in a different account rather than spend it.
Luckily, there are other options. You can choose to keep the money in the 401(k) and let it grow over the years, but it can be difficult to keep track of your different accounts from each company you have worked at. Another option is asking your former employer to transfer the balance to a new account, which helps to avoid any fees or penalties and keeps all of your retirement money in a more centralized location.
6. Take distributions
Just because you’ve finished adding to the principal of your 401(k) account does not mean that you’re finished managing your account. These accounts have required minimum distributions starting at the age of 70 1/2. At this point, you must make minimum withdrawals on an annual basis or face a hefty penalty: 50 percent of the amount that should have been withdrawn. Since you may draw on multiple accounts during retirement or you may not be retired come this age milestone, making the withdrawal can sometimes fall through the cracks and result in a significant loss. Notably, this rule only applies to a traditional 401(k) account. With a Roth 401(k), there are no mandatory annual distributions.
Many people struggle when it comes to choosing the best retirement account because, in part, choosing the right account involves making predictions about the future. But how can you tell if a traditional or Roth IRA is best for you?
Roth accounts are relatively new, as they were only introduced in 1998. In the most basic sense, Roth IRAs can help you to avoid tax ramifications down the road since any contributions are made after taxes, meaning that withdrawals are not taxed. They also have a number of benefits; for instance, you are able to withdraw prior to retirement without penalty and continue making contributions after turning 70 ½ (traditional IRAs require you to take required minimum distributions starting at this age).
While these benefits may make Roth accounts sound attractive, they do not always make sense for everyone. Generally, the decision between Roth or traditional IRAs comes down to how much a person is currently making and how much that person plans to make in the future. Roth accounts make the most sense when people think that they will have a higher income in retirement than they do now, meaning that they would be taxed at a higher rate later than they are now. Individuals who expect to earn less during retirement than now typically should opt for a traditional account since it will allow them to enjoy a lower tax rate in retirement.
The Benefits of Roth Accounts for Young Earners
Typically, a Roth account makes the most sense for young workers who have not yet fully realized their earning potential. Young workers often have an effective tax rate in the low single digits, and it is highly likely that they will be in a higher tax bracket once they retire. Front-loading the tax burden makes sense for them since it will save money down the road. In addition, investments grow tax-free in Roth accounts, an important consideration for young workers as the money will likely accrue compounded interest over the course of decades. When these individuals reach retirement, they will be able to spend all the money they have accrued without worrying about paying any taxes.
However, young workers should also consider that, since their contributions are taxed, they will need to divert more of their monthly income to retirement to make the same impact as non-taxed accounts. In a sense, Roth accounts require that individuals pay both the contribution and the taxes to a retirement fund.
At the same time, if a young worker made maximum contributions to a traditional retirement fund and then invested the tax they saved into a Roth, they would likely end up paying more in taxes than if they used a Roth to begin with, due to the required tax on the investment growth.
The Primary Strategy for Older and Higher Earners
Once individuals start to approach the peak of their careers, a Roth account stops making a lot of sense. Individuals who have high salaries, and who are thus in higher tax brackets, will likely experience a lower tax rate during their retirement years. As such, they may do best to choose a traditional account, which will defer taxes for the future.
For the highest earners, this may actually prove a moot point since there are income restrictions for opening Roth accounts. In 2019, the IRS is prohibiting people from contributing to a Roth account if they earn more than $137,000 annually as a single person or more than $203,000 as a married couple. There are some strategies for getting around this rule, but people generally do not have a compelling reason to do so, especially considering that traditional IRAs do not have income caps for contributions.
Higher earners with traditional accounts can also enjoy a lower adjusted gross income (AGI). Pre-tax contributions are deducted from the AGI, whereas post-tax deposits into a Roth IRA are not. A lower AGI can help maximize the Saver’s Tax Credit for people who make contributions to traditional plans, although this credit mostly applies to individuals with modest incomes or AGIs below $64,000 for joint filers.
The Benefits of Having Both Traditional and Roth Accounts
The people who may have the most difficulty deciding between a Roth or traditional account are those in the middle of their careers. These individuals probably do not have a clear idea about their future tax status. In this case, it can make sense to contribute to both a Roth and a traditional account at the same time. This strategy is akin to hedging their bets, although individuals should note that combined contributions cannot exceed $6,000 annually or $7,000 for people over the age of 50, according to current tax law.
However, there are some other advantages to investing in both. During retirement, people may have low tax years, such as when they have significant long-term care expenses. During these years, it makes sense to take from traditional accounts. These same individuals can also have high tax years, especially with large capital gains. In these years, distributions can come primarily from Roth accounts.
Most people think about putting money away for retirement as “savings.” However, these accounts are really a form of investing today’s income in the hopes that it grows and provides a nice nest egg for the future. As with any investment, retirement accounts come with a certain amount of risk.
The amount of risk with which someone is comfortable depends on the person, as well as the situation. With retirement, individuals often try to reduce risk as they approach their sixties to protect the money that they have saved since there is less time for rebound.
Managing risk when it comes to retirement savings starts with understanding what risks exist. This is particularly true in light of the fact that more investment decisions are falling to the individual than ever before. Some of the key risks involved with retirement savings include:
Perhaps the most obvious (but still frequently overlooked) risk is inflation. Because of high inflation rates, the money that is put aside now will simply not be worth as much in terms of purchasing power in the future.
Since 1981, the inflation rate has been about 2.8 percent annually. That means people need to earn a return on investments of 2.8 percent just to break even when it comes to inflation.
Furthermore, inflation tends to be higher for retirees largely because of healthcare costs, which have actually grown at a rate that outpaces general inflation. Individuals should always think about inflation in terms of their low-risk investments, which may not even break even if they have a very low rate of return.
Sequence of Returns
The phrase “sequence of returns” refers to the state of the market during the time withdrawals are made. When retirees need to withdrawal from an investment account during a bear market, they will deplete their savings far more quickly than in a bull market.
This is exacerbated by the fact that depleting one’s savings limits the amount of money left to generate returns going forward. While most people focus on the average rate of return before retirement, afterward it is quintessential to consider the sequence of returns. Perhaps this consideration becomes most important when thinking about when to retire.
Ideally, individuals retire during positive market performance. This minimizes the need of liquidating investments to generate an income. When the liquidation happens, individuals may find themselves running out of money before predicted.
While the subject of longevity may seem morbid, it is a critically important consideration for people facing retirement. When it comes to retirement risk, longevity refers to how long individuals will actually live. Funding a retirement that lasts 20 years is significantly less challenging than making the same money last for 30 years.
While no one can predict exactly how long they will live, this consideration does have an impact on how fast individuals spend money once they have retired. Even individuals with a very solid foundation will have trouble generating enough income for 30 years. Yet people today are living longer than ever before, with many individuals living until their late nineties.
Current interest rates are considered fairly low. Retirees should recognize this fact because it means that they can generate only limited returns with “safe” investments, such as Treasury notes. While these notes once generated a return of more than 5 percent, or even 7 percent in the early 1990s, they now have a return of about 2 percent, which does not even cover inflation. As a result, individuals may have to save more than they initially thought when they started saving a few decades ago.
Another strategy is to move these investments into more aggressive accounts with the potential for greater yields, but this comes with the risk of losing considerably. While rates could increase, it leaves many people just starting to save relying on riskier options for the time being.
Healthcare costs continue to increase rapidly. People who do not plan for these expenses may find themselves going bankrupt when something happens. Before retirement, individuals need to think critically about their needs and prepare as best as they can. Looking at current health and genetics can say a lot about likely needs in the future. This will help direct people toward the best options for them.
Individuals also need to consider the level of care that they want. Private nursing homes cost much more than other options. To offset health costs, individuals can purchase long-term care insurance or supplemental policies for Medicare. However, it may also be prudent to save more than initially thought necessary for healthcare expenses, just in case.
Laws can change quickly, creating completely new tax situations. These risks are hard to predict, but they could really take a bit out of retirement plans. For example, taxes could skyrocket, which leaves individuals with traditional retirement accounts with much less money than they thought when they start to withdrawal funds.
On the other hand, people who prepare for this issue by investing primarily in Roth accounts may kick themselves if taxes are much lower when they start making withdrawals than they currently are. Many people try to mitigate this risk by investing in both traditional and Roth accounts so that they can be more strategic in how they withdraw down the road.
It is important to begin saving for retirement as early as possible. Fortunately, it is never too late to take control over retirement planning. Even in the decade leading up to retirement, there are important steps that individuals can take to maximize their savings. This is particularly true if they need to catch up in order to meet their goals.
Individuals in this situation should not feel alone. A survey conducted a few years ago found that three out of 10 individuals over 55 have no retirement savings at all. About 25 percent of responders had less than $50,000. These situations are serious, but all hope is not lost. The key last-minute steps to take when it comes to saving for retirement include:
Delay pulling on Social Security.
The age at which someone starts pulling on Social Security has a big impact on the monthly benefit. When individuals claim before their full retirement age, which is either 66 or 67 depending on birth year, the payments are reduced.
On the same token, payments increase by delaying retirement, at least up to the age of 70. Individuals who choose to retire at 70 will maximize their monthly benefit.
To see how much of an impact this will have in each individual’s particular situation, people can visit the Social Security website and track the payments that they would receive retiring between the ages of 62 and 70. People who are already behind on saving definitely need to make the most of this important benefit. The added effect is that this delay gives people even more time to save.
Diversify accounts to minimize taxes.
Once people retire and start to pull on their traditional 401(k)s and individual retirement accounts (IRAs), they will need to pay taxes on withdrawals. Furthermore, withdrawals become mandatory once individuals reach the age of 70 and a half.
These tax payments can significantly cut into the amount of money available for everyday living. People can help offset this issue by diversifying their retirement savings with a Roth 401(k) and/or a Roth IRA. Both of these accounts require that individuals invest after-tax money, but then no taxes are due upon withdrawal.
Diversification of accounts can help provide better planning for the future since individuals know more fully how much they will have to spend. With fluctuating tax rates, planning with traditional accounts becomes more difficult.
Downsize or consider a reverse mortgage.
One of the best strategies that individuals can undertake to increase retirement savings is downsizing their home, which in turn reduces cost of living. People often find this step necessary to survive in retirement anyway. Doing it early can mitigate some of the headaches that would otherwise come down the round.
However, individuals who wish to stay in their home can consider a reverse mortgage to help cover monthly bills. Such a loan is only available to people over the age of 62.
However, it does come with disadvantages that individuals need to consider. People will need to repay the loan to move. Additionally, they will not be able to leave the home to children unless they pay back the money. Also, these loans often involve a number of fees.
Reduce retirement savings fees.
Once people retire, they have the option to roll over the savings in a 401(k) into an IRA. If individuals have great investment options with the IRA and low fees, meaning less than one percent, then it makes sense to transfer money into that account. While this may not seem like a big deal at first, this move can easily translate into thousands of dollars of savings over the course of retirement.
The best part of this savings is that it requires only a one-time action on the part of the retiree and the savings will continue throughout retirement. These savings are quite significant when one considers how percentage fees compound.
However, individuals should make sure that they perform their due diligence before reinvesting the money. Any IRA should have adequate investment options for meeting realistic goals and charge low fees.
Create a strategic financial plan.
Ideally, individuals create a comprehensive financial plan for retirement savings early in life, but sometimes other factors get in the way. Even people who save diligently face emergency situations that require them to drain accounts.
When approaching retirement with less-than-ideal savings, it is more important than ever before to account accurately for monthly financial needs and figure out how to make the ends meet. Often, this means curbing spending right now to get as much into retirement plans as possible. Sometimes, individuals find that they will need to get a part-time job to cover their monthly expenses once they retire.
However, it is impossible to know these things without mapping out how much people’s financial requirements in retirement and their projected monthly expenses. Of course, much of this practice is prediction, but it also provides some needed guidance for future planning.