How To Maximize Your IRA Contributions – Forbes Advisor

You put money in an individual retirement account (IRA). Great! A whopping 42% of those under 30—and 26% of those between 30 and 44—have no retirement savings, according to recent research by PwC, so just by doing that, you’re already ahead of the game.

But don’t stop there. Many retirement savers make the mistake of throwing cash into an IRA every year at tax time and then don’t think much more about it. That neglect can cost you a lot of money, both today and at retirement age. You worked hard to get that money; here’s how to make sure your IRA makes the most of it.

1. Don’t Just Fund Your IRA. Invest Your Money

A big mistake many retirement investors make is contributing money to an IRA or other tax-advantaged account—usually inspired by an April 15 deadline—but then failing to actually invest that money thoughtfully. In worst-case scenarios, these contributions sit idly in a money market account, generating one or two pennies a year for every $100.

Unfortunately, this happens all the time. A Vanguard study a few years ago found that two-thirds of last-minute IRA contributions end up sitting in money market funds, which are often basically glorified checking accounts. Don’t make the mistake of letting your funds sit idle. IRA contributions should be actively placed in an appropriate investment—perhaps a target-date mutual fund, perhaps some bond funds, perhaps some carefully chosen individual stocks. All of these have the potential to net you higher returns than a simple money market fund.

Also, make sure you don’t settle for the default choice for your IRA investment—perhaps a choice you made in your 20s or an option foisted upon you back when you had a 401(k). IRA holders, unlike most 401(k) savers, have an entire market’s worth of options. That means you’re even better able to make sure you aren’t paying into pricey funds that eat into your long-term returns. Remember: Most experts recommend you invest for retirement in low-cost index funds. This positions you for optimal growth with minimal costs.

2. Pick the Right Kind of IRA

You might know there are traditional IRAs and Roth IRAs, and you might even know their chief distinction: Roths let you pay taxes today and enjoy tax-free withdrawals in the future while traditional IRAs give you a tax break today but force you to pay taxes later. Which should you choose?

The simple rule of thumb goes like this: If you think you’ll be in a higher tax bracket at retirement, choose a Roth; otherwise, take the tax break now.

As with all things money, however, the Roth vs traditional choice is not nearly so simple. Maybe you expect lower income in retirement, but you also think tax rates will go up, so you still think a Roth is the better choice. Maybe you need the tax break now for other reasons. And, it should be noted, how the heck do you know what you’ll be earning 30 or 40 years from now?

There is one more important consideration in the Roth vs traditional calculus: Traditional IRA holders must start taking required minimum distributions (RMDs), which are mandatory withdrawals, at age 72. That might hurt you at tax time as these count as income (remember: you opted to avoid paying taxes on these years or decades before). Roth holders, meanwhile, face no RMDs. That’s what makes them a popular choice for families looking to preserve generational wealth: Not only do Roths avoid mandatory withdrawals but they also can be inherited with no tax burden to the recipient. Inherited traditional accounts, on the other hand, come with an associated tax bill.

So it’s not a simple choice. It’s best to get advice from a professional when making it, but the advice here is the same as above: Make a choice; don’t just accept a default. And always be willing to change if new information comes your way.

3. Convert, If That Works for You

Here’s a potential life development you might not see coming: In the future, you may volunteer to pay taxes on your previously untaxed traditional IRA savings and convert them into Roth dollars. Why would anyone do that?

It might make sense for someone who suffered a steep mid-career income loss (say, during a pandemic) and suddenly finds themselves in a lower tax bracket. Or a conversion can make sense if tax rates are temporarily lowered (say, by Congress). If the idea is to pay taxes on your retirement savings in the most tax-efficient way, paying them in a down-income, down-tax-liability year could make a lot of sense.

And there’s another advantage to Roth conversions: People who earn too much to be eligible for a Roth ($140,000 annually as a single person in 2021) can be eligible for a conversion (sometimes referred to as a backdoor Roth). But be careful: Moving IRAs and closing accounts brings with it the peril of making a big tax mistake. So this step is best taken with professional help.

4. Don’t Pay the Procrastination Penalty

It feels good to make that full-sized IRA contribution on April 15 ($6,000 for individuals in 2021) and take the tax break for the prior year. But by doing so, you’ve left more than 15 months’ potential investment returns on the table. That $6,000 should have been invested during the prior year, placed in a mutual fund or stock the whole time, ideally as early as possible. Delaying until the last possible minute often adds up to a very expensive procrastination penalty. For example: $6,000 invested in an S&P 500 mutual fund on Jan. 1, 2020, would have been worth about $7,660 on April 15, 2021. If you do this every year, just imagine the missed gains over a 30- or 40-year career!

5. Pick Stocks vs Bonds Like a (Tax) Pro

This tip goes out to the tax nerds (but really, everyone should be a tax nerd). If you are lucky enough to maximize your tax-advantaged retirement account contributions and have some left over that you save in standard investment accounts, consider buying bonds in your IRA and stocks in your standard account. Why?

Bond dividends are taxed as ordinary income while stocks and stock-filled mutual funds often generate capital gains. These aren’t regular payments you receive from your stocks but rather the increase in their sticker price from year to year. This distinction is important because these so-called capital gains, which only occur when you pull the trigger and sell a stock or fund, are taxed at a lower rate. That’s why it’s helpful to hold them in a taxable investment account while you save your tax-advantaged accounts for investments or funds that may have large taxable annual income payments. Remember, regardless of which IRA you choose, you’ll never pay taxes on money while it stays in your account.

There are plenty of exceptions to this guideline, of course: Mutual funds with a very active manager can generate ordinary income as well as substantial capital gains, so investments in those kinds of funds might still be better off in an IRA. But this rule is worth following for those looking to game their way to a lower tax bill; just make sure you’re aware of how your income and capital gains may manifest so you’re able to put the right investments in the right accounts.

6. Do Take Risks

It seems every decade or so there comes a drastic reminder that investing brings no guarantees. People can and do lose money. Returns never follow a straight line. People who ignore this reality eventually get hurt, sometimes badly. But…long-term investing has so far never failed to generate good returns.

How does one define long-term?

Well, it’s impossible to find a 20-year span during which the S&P 500 didn’t generate positive returns, according to data analyzed by MyPlanIQ for Seeking Alpha. And over 15 years, there was only one instance when investors may have slightly lost money, to the tune of just 0.3%. What’s more, since 1871, the S&P 500 has increased by about 9% on average each year. This accounts even for enormously down periods like the Great Depression and Recession.

All of this means one thing: When it comes to retirement investing, time is on your side. Risk is your friend. Invest the money. Parking your cash in a money market account, or under your bed, in an attempt to avoid risk is actually the riskiest step of all.