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IRA mistakes to avoid

What we'll cover

  • Common mistakes when managing retirement funds

  • 2023 IRA contribution and income limits 

  • How to avoid penalties and fees

It’s never too early to start saving for retirement and it’s certainly never too soon (or too late) to get familiar with your retirement savings options. Knowing the basics surrounding the tax advantages of your Individual Retirement Account (IRA) is an important part of the process.

Having a solid grasp of how an IRA works may help you save, simply by following the rules. In this piece, we’ll cover the top 10 IRA mistakes the average person makes and how you can avoid them so you’re hopefully more on track for the retirement you want. 

Mistake 1: Underestimating how much money you’ll need in retirement

The last thing anyone wants is to run out of money later in life. It’s impossible to think about what the world will be like when you retire, so it’s wise to save more than you think you’ll need.  

Every person has a different retirement plan based on when they retire, where they live after retirement and the lifestyle they want to have. There’s no one-size-fits-all plan, but a general rule to follow is to have enough to cover 80% of your pre-retirement income.  

For example, if you make an annual salary of $100,000, you’ll want to have approximately $80,000 available per year to spend to maintain your current lifestyle (if you’re saving 15% of that income each year and paying income taxes, you’re already used to living on roughly that same amount!). While you may have support from Social Security, you’ll still maybe want to save at least $50,000 for each year of retirement to reach that $80,000 goal. If you plan to be retired for 20 years, that adds up to $1 million stocked away in your IRA. 

If you’re accustomed to a more modest lifestyle, these numbers may feel overwhelming. By breaking them down over time and giving yourself a solid head start by starting to save at a younger age, the total isn’t as daunting. It is all in the planning! 

Having a solid grasp of how an IRA works can help you save — and earn — over time, simply by following the rules

Mistake 2: Not knowing the differences between IRAs

The four common types of IRAs are traditional, Roth, SEP, and SIMPLE.

With a traditional IRA, your contributions may be tax deductible, meaning you may not owe income tax on your contributions or earnings until you make a withdrawal. Traditional IRAs are a great option if you want to lower your taxable income upfront, but those deductions are subject to income limits. 

Keep in mind: You will have to pay taxes on both traditional IRA contributions and earnings when you withdraw the money in retirement, but since it’s possible your annual income will be lower, you could be taxed at a lower rate. 

On the flip side, a Roth IRA requires a degree of patience to understand the tax benefits. While your contributions are made with income that has already been taxed, money grows tax-free and distributions are tax-free during retirement. Withdrawals of earning before age 59½ may be subject to taxes and penalties. You can also withdraw contributions (not earnings) from your Roth IRA at any time without penalty — a benefit you don’t get with a traditional IRA. 

A Simplified Employee Pension (SEP) IRA is similar to a traditional IRA although it is a retirement plan typically used by small business owners or self-employed workers. However, if the business owner has employees, all must receive the same benefits under the SEP plan.

Along similar lines, Savings Incentive Match Plan for Employees (SIMPLE) IRAs are typically utilized by small companies with fewer than 100 employees who earned at least $5,000.00. Like a 401(k) for small businesses, employees can direct a portion of their paycheck automatically into the account and employers are mandated to match contributions up to 3% of the employee’s salary. Or employers can set up a non-elective contribution method, in which employees aren’t required to contribute, and employers make contributions equal to 2% of the employee’s salary. 

Types of IRAs - (Traditional)-Contributions may be tax deductible (income limits exist), owe income tax on contributions and earnings when you make a withdrawal in retirement. (Roth)-Contributions are taxed, (income limits exist),  distributions are tax-free in retirement, can withdraw contributions without penalty. (SEP)-For business owners or self-employed workers, similar to a traditional IRA. (Simple)-For companies with fewer than 100 employees, contributions are tax-deductible; employers can make contributions or match workers’ contributions up to 3%.

Mistake 3: Contributing too much

In 2023 the limit for traditional and Roth IRA contributions for those under 50 years old is $6,500 per year and $7,500 per year for those 50 and older. These are up from 2022 limits of $6,000 and $7,000, respectively. 

If you have multiple IRAs, these limits apply to the total amount individually contributed, not each individual account. If you contribute more than the limit, you’ll incur a 6% excess contribution tax — unless you catch the error before filing taxes, when you can withdraw the money to avoid fees. 

A SEP IRA allows your employer to contribute significantly more — up to $66,000 or 25% of compensation (whichever amount is lower). Unlike traditional and Roth IRAs, a “catch-up” contribution doesn’t exist for workers who are 50 years of age or older and have a SEP IRA. 

SIMPLE IRAs let employees contribute up to $15,500 per year in 2023 (plus an additional $3,500 in 2023 as a catch-up contribution for those 50 and older). 

Mistake 4: Not knowing income limits

Yes, there are more than just contribution limits to be aware of. Roth IRAs have limits regarding your modified adjusted gross income (AGI).  

As of 2023, those married filing jointly must have a modified AGI less than $214,000 for the 2022 tax year and $228,000 for 2023 to contribute to a Roth IRA. However, you can only contribute a reduced amount unless your modified AGI is less than $218,000 for the 2023 tax year.

For single, head of household, or married filing separately (“single”, in short) tax filers, modified AGI must be less than $144,000 for the 2022 tax year and $153,000 for 2023 to contribute to a Roth IRA.  However, you can only contribute a reduced amount unless your modified AGI is less than $138,000 in 2023. (Those earning more cannot make Roth contributions).   

Finally, married filing separately and having a modified AGI of $10,000 or more aren’t eligible to make Roth IRA contributions at all. (If you make less than $10,000, you can contribute a reduced amount). 

There are no income limits for a traditional IRA, but if you are covered by a retirement plan at work and your modified AGI exceeds a certain amount (greater than $116,000 for married filing jointly, greater than $73,000 for those filing as “single” filer) your contribution may not be eligible for a full tax deduction. 

Mistake 5: Waiting too long to contribute

The deadline for contributing to your IRA is tax day (mid-April) each year. For the 2023 tax year, this means you can start contributing on January 1, 2023, and may continue adding to your IRA until April 15, 2024

Ideally, you’ll contribute as much as you can (up to the limit) as early as possible to allow more time for compounding interest. But not everyone has thousands of dollars lying around come the first of the year. Fortunately, there are other savings strategies you can utilize.

Set up automatic payments (monthly, bi-monthly, or another cadence that works for you) that move money over time and allow you to avoid last-minute contribution panic. This practice utilizes “dollar-cost averaging,” which means you’re regularly investing in the markets regardless of market fluctuations. One month you might buy higher, but another month you could buy at a more affordable price. 

Mistake 6: Withdrawing too early (or the incorrect amount)

The typical withdrawal rule of thumb is as follows: You can’t take any money out from your IRA before age 59 1/2, and if you do, you’ll generally pay ordinary income taxes and a hefty 10% early withdrawal penalty (though there are some exceptions, like using the money for higher education or buying your first home). While Roth IRAs are more lenient when it comes to withdrawing contributed money (since contributions have already been taxed), you will typically have to pay ordinary taxes and a 10% early withdrawal penalty for earnings withdrawn early before age 59 1/2. 

Roth IRAs also have a five-year rule for distributions, which stipulates that five years must pass from the beginning of the tax year of your first contribution in order for earnings to be withdrawn tax-free. For example, let’s say you made your first contribution to your Roth IRA at age 57 in early 2023. Although you’d turn 59 1/2 in late 2025, your distributions wouldn’t yet qualify for tax-free withdrawal, since five years haven’t passed.

Traditional IRAs have a Required Minimum Distribution (RMD) that goes into effect once you’re later in retirement. A RMD is the amount of money you must withdraw from a traditional IRA each year. It’s calculated by the IRS and takes into account your IRAs remaining balance(s) as well as your life expectancy. 

Your first RMD must be taken no later than April 1, 2024 after you turn age 73 starting on January 1, 2023. Failure to withdraw the specified value annually results in paying the original taxes owed, plus a 25% excise tax penalty. The 25% excise tax can be reduced to 10% if you correct the failure in a timely manner.  After the first year, you’re required to take out your RMD annually by December 31st.

Mistake 7: Rollover mistakes and losing money

At some point, you may find yourself needing to move retirement funds around in some way, so it’s important to know how to do so without paying penalties or taxes. When it comes to your IRAs, you can transfer, rollover or conduct a conversion of your retirement money. 

A transfer moves funds from one account to another account of the same type (a Roth IRA at one financial institution to a Roth IRA at a different institution) without taxes. A rollover moves funds from one account to a similarly registered account or to a different type of account (such as a 401(k) to a traditional IRA). Finally, a conversion changes a traditional IRA to a Roth IRA resulting in paying taxes on any untaxed amounts.

If done improperly, rolling over funds can leave you with a heftier tax bill, early withdrawal fees and/or penalties. Consulting with a tax professional or financial planner can typically help you to avoid money-moving mistakes and have your funds in the types of accounts that offer the most benefits for your financial situation. 

Mistake 8: Forgetting your beneficiaries

Just like with your other bank and finance accounts, it’s important to have a beneficiary, a designated person to whom those assets will go to when you pass away. Not the most fun task, but all the same important. Without a named beneficiary, you leave loved ones to sort out your finances.

Unlike a 401(k) plan, where you’re often required to name your spouse as a beneficiary, an IRA typically allows you to name anyone (unless state laws say otherwise), and you can often name more than one person.  

Mistake 9: Not seeking advice on an inherited  IRA

If you are the beneficiary of a spouse or other loved one’s IRA, there are some key things to know before making any moves with that money. Rules and regulations are different for inherited IRAs than those for your own IRAs. 

You’ve got a variety of options depending on your relationship to the person who passed, their age and other factors. With these complexities in mind, it will serve you well to consult a financial or estate planner to narrow down your options and determine the best path based on your goals. 

Mistake 10: Missing out on a backdoor Roth IRA

A backdoor Roth IRA isn’t another type of account, it’s a strategy typically used by high-income earners who exceed Roth IRA income limits. This approach converts a traditional IRA to a Roth IRA in one of three ways:

  • Contribute funds to a traditional IRA then roll them over to a Roth IRA (there is no cap on how much you can roll over at one time, although the IRS has more complicated pro-rata rules that apply).

  • Convert your entire traditional IRA to a Roth IRA

  • Roll over a 401(k) account to a Roth IRA (if your employer allows it)

As long as it’s done correctly, a backdoor Roth IRA is legitimate. You’ll still need to pay taxes on any money in your traditional IRA that hasn’t been taxed.

IRAs may seem like a simple way to shelter your money from taxes and capital gains at first, but the devil is in the details when it comes to your retirement savings. Strengthen your knowledge so you can avoid these common mistakes and become a savvy saver from the moment you open your IRA .

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