Individual retirement accounts held an estimated $4.7 trillion in 2010, which is just over a quarter of all retirement assets in the United States. Some 49 million Americans had at least part of their nest egg stashed in an IRA last year. How well you choose IRA investments and minimize taxes using these accounts will play a big role in how prepared you are for retirement. Here are 10 things you should know about your IRA.
Delay or pre-pay your taxes. Traditional IRAs allow you to defer paying taxes on up to $5,000 of retirement savings, or $6,000 if you are age 50 or older. Upon withdrawal, regular income tax is due on your savings and the interest. Roth IRA contributions are made with after-tax dollars and withdrawals in retirement from accounts that are at least five years old, including the earnings, are tax-free. Investing in both types of retirement accounts can add tax diversification and flexibility to your portfolio.
Later contribution deadline than 401(k)s. While you generally must make contributions to employer-based retirement accounts by December 31, you have until the date you file your taxes to make IRA deposits. If you make a contribution to an IRA between January 1 and your tax deadline, you should tell the financial institution which year the contribution is for. You can file a tax return claiming a traditional IRA deduction before the deposit is actually made, but the contribution should be in the account by the due date of your return.
Most IRA money is rolled over from 401(k)s. More than 10 times as many dollars are added to IRAs through rollovers than through direct contributions, according to an Employee Benefit Research Institute analysis of 14.1 million accounts containing $732.9 billion in 2008. Depending on their age, retirement savers can contribute up to $5,000 or $6,000 annually to an IRA, but there is no limit on the amount that can be rolled over to an IRA from a 401(k) or other retirement account after a job change or upon retirement. The average rollover amount was $74,785 in 2008, compared with an average individual contribution of $3,666.
Older age for retirement withdrawals. Workers who leave their jobs at age 55 or later (or age 50 for public safety employees) can take penalty-free 401(k) withdrawals at age 55. If retirees roll that money into an IRA, they will have to wait until age 59½ to avoid the penalty. "If someone is 56 and they are retiring, they should roll over the part of the 401(k) they are not going to foreseeably need in the next few years and leave in the 401(k) what you need in the next few years," says David Hultstrom, a certified financial planner and president of Financial Architects in Woodstock, Ga.
Penalty-free early withdrawals allowed. There are several ways to avoid paying the 10-percent tax for taking withdrawals before age 59½. You can take penalty-free early withdrawals if you have unreimbursed medical expenses that are more than 7.5 percent of your adjusted gross income, use the withdrawal to pay for health insurance after losing your job, become disabled, or are a military reservist ordered to active duty. You can also use the money to pay for higher education expenses or a first home purchase up to $10,000 ($20,000 for couples) without incurring extra charges. Setting up equal annuity payments from the IRA over your life expectancy or over the joint life expectancies of you and your spouse can also allow you to avoid the 10 percent tax.
You are responsible for shifting your investments. Almost half (46 percent) of IRA assets are invested in the stock market. The most popular IRA investments are equity mutual funds and individual stocks (39 percent), cash (22 percent), bonds (14 percent), and balanced funds (12 percent), according to EBRI research. Individuals must choose their own investments and are responsible for shifting those assets appropriately as they approach retirement. "Those who are younger and in the accumulation stage are more likely to be invested in equities," says Craig Copeland, a senior research associate at the Employee Benefit Research Institute and author of the report. "Older investors and those with bigger account balances are diversifying across many assets and focused on the preservation of income."
Roth option increasing in popularity. The $100,000 income limit for converting a traditional IRA to a Roth IRA was eliminated in 2010. Since then, there has been a surge in Roth IRA conversions. Many financial institutions, including Fidelity Investments, Vanguard, and Bank of America, reported four- and five-fold increases in the number of Roth IRA conversions executed in 2010. Vanguard, for example, completed more than 170,000 Roth conversions from the beginning of 2010 through December 16, up 550 percent from 2009. Retirement savers must pay income tax on the amount converted from a traditional IRA to a Roth IRA, but withdrawals will be tax-free in retirement. "You are paying upfront to remove the uncertainty of what future tax rates will do to your savings," says IRA expert Ed Slott, founder of irahelp.com and author of Stay Rich for Life!: Growing & Protecting Your Money in Turbulent Times.
Withdrawals are required. You cannot shield money from taxes in a traditional IRA indefinitely. Distributions become required after age 70½. Those who fail to withdraw the correct amount must pay a 50-percent excise tax on the amount not distributed as required. You must take your first required distribution from your IRA by April 1 of the year after you reach age 70½. But in subsequent years, annual distributions are required by December 31. If you delay your first distribution until April, you will need to take two withdrawals in the same year, which could impact your income-tax rate. "For some people, two in the same year might be enough to throw them into a higher tax bracket," says Hultstrom. Withdrawals from Roth IRAs are not required in retirement.
Costs matter. Retirement savers using IRAs sometimes pay higher fees than those with a 401(k) because individuals no longer have the group's bargaining power to obtain lower-cost investment products and tend to make high-cost investment choices, according to a 2009 Government Accountability Office report. Pay attention to the fees and costs of each investment option and switch into similar low-cost investments when possible. "A 1-percent difference in fees over a lifetime makes a really big difference," says Slott.
Special perks for high and low income savers. Retirement savers age 70½ or older who are in the fortunate position of not needing the money in their IRA can avoid paying income tax on their required minimum distribution of up to $100,000 by donating it to a charity by Dec. 31, 2011. To qualify for the tax exemption, the IRA trustee must make the distribution directly to a qualified charity. Low-income workers who save for retirement may be able to claim a tax credit. If your modified adjusted gross income is less than $28,250 ($56,500 for couples) in 2011 and you contribute to an IRA or 401(k), you may be able to claim the saver's credit. This nonrefundable credit is worth up to $1,000 for individuals and $2,000 for couples.