If you’re going to have investment accounts, don’t trust your financial advisor or company HR department to make all of your decisions for you. You might have some trusted advisors around you, but the decisions are ultimately yours. Don’t make costly mistakes based on lack of knowledge. Avoid these common IRA mistakes.
Not Understanding the Different Types
Not all IRAs are the same. From a tax perspective, they’re wildly different. A traditional IRA taxes you when you withdraw the funds and may come with a tax deduction at the time when you contribute the funds.
A Roth IRA has no tax deduction when you contribute. You pay normal taxes on the funds before depositing into the IRA, but there’s no tax when you take it out at retirement. The Roth also has income limits, so if you’re fortunate enough to make over $140,000 as a single, or over $208,000 as a married couple, in 2021, you won’t be able to contribute without some clever workarounds.
You might choose a Roth IRA if you believe that you’re going to make more money later in life and want to pay taxes on the money in your current tax bracket.
If you don’t believe that, or you don’t believe that tax rates, as a percentage of your income, are going to rise, a traditional IRA might be more suitable for you.
Understanding the Loopholes
Ever wonder why the United States tax code has over 70,000 pages? In part because of the loopholes that people have found over the years. For example, if you want to contribute to a Roth IRA, but you’re over those income limits, you can contribute to a nondeductible IRA and later move the funds to a Roth IRA.
A nondeductible IRA is nothing more than a traditional IRA without the tax deduction.
Believe the Money Is Off-Limits Until Retirement
You’ve probably read articles that throw down some pretty strong language about taxes on withdrawals and the 10% early withdrawal penalty if you put your hands on your money before age 59.5. Those warnings are correct with some notable exceptions.
Let’s start with Roth IRAs. The money you use to fund your account (the contributions) has already been taxed. That means that you’re free to withdraw your contributions at any time for any reason. Just don’t touch your earnings—the money you make on the contributions.
You can also withdraw from a traditional IRA without paying the 10% penalty for a first-time home purchase. As long as the account has been open for five years and you’re taking out less than $10,000 per person, you will only pay income taxes, if applicable.
There are other reasons you can withdraw funds, but try to avoid it, if at all possible.
Taking Money Out Too Early
Just because you can doesn’t mean you should. According to a 2019 report from the Federal Reserve, 44% of non-retired adults don't their retirement is on track. In other words, you need every dime you can get into that account earning money for you.
When you make a withdrawal, you’re losing the power of that money to generate more gains, and you’re paying income taxes and possibly a penalty.
You could lose as much as half of your withdrawal to taxes and penalties. Unless it’s a really good reason, like healthcare, for example, try your best to not touch the funds.
Not Nailing the RMD
Traditional IRAs require you to take required minimum distributions (RMD) once you reach age 70.5, even if you don’t need the money. If you don’t, you could pay a penalty of up to 50% of the distribution. Want to avoid RMDs? Get a Roth IRA instead.
Overfeeding Your IRA
Too much of a good thing becomes a bad thing. You can only contribute $6,000 per person to a Roth or Traditional IRA in 2021. Or $7,000 if you’re age 50 or over. If you contribute over that amount and catch it before you file your taxes, take the money back out. You won’t owe any taxes or penalties unless you made money while it was in the account.
Forgetting About Beneficiaries
A good custodian will hound you about beneficiary paperwork. An even better custodian won’t let you open the account without the forms on file, but that’s not always the case. Depending on the laws in your state, the lack of properly completed beneficiary forms can cause a great deal of headache to the people already mourning your loss.