An individual retirement account can be a great way to build a financial foundation for your later years. A Traditional IRA offers the advantage of being able to deduct your contributions, reducing your taxable income for the year in the process. The tradeoff is that you’ll pay taxes on what you save when you begin making withdrawals in retirement.
The current annual contribution limit for Traditional IRAs is set at $5,500, or $6,500 for savers age 50 and older. Saving the maximum allowed in your IRA each year is a good way to pad your nest egg, but it’s not the only way to make the most of your account. Here’s how you can get even more mileage from your Traditional IRA.
Be the Early Bird
When saving for retirement, procrastination doesn’t pay. Getting an early start is in your best interest, even if you’re not fully funding your IRA in the beginning. Time can be the most powerful weapon you have as an investor because it allows you to take advantage of compound interest. This is essentially interest that you earn on your interest. The longer your time horizon for saving in an IRA, the longer your money has to grow on a tax-deferred basis.
Choose Your Savings Strategy
There are two ways to fund your Traditional IRA: You can invest a lump sum of cash all at once or make smaller contributions throughout the year. The idea behind dollar-cost averaging is simple. You invest a set amount of money regularly, buying shares in stocks or mutual funds. The prices of those investments may fluctuate but because you’re investing consistently, you keep your focus on investing for the long-term, versus making decisions based on current market conditions.
While dollar-cost averaging is a popular choice, investing a lump sum in your IRA may prove to be the better strategy. Research from Vanguard shows that an “immediate” lump-sum amount in a portfolio that includes a 60/40 mix of stocks and bonds outperformed dollar-cost averaging by a margin of 2.4 percentage points on average during a 12-month period. Even when the mix of assets was shifted more aggressively or conservatively, lump-sum investments still performed better.
Whether a lump sum or dollar-cost averaging makes more sense depends on what you have in reserve. If you have enough to fully fund your Traditional IRA right away, that could be a more efficient way to max out your account for the year because it can start earning income right away.
Pick the Right Investments
Traditional IRAs give you lots of ways to invest, but some investments are better suited than others from a tax perspective. Selecting investments that offer the most growth potential—while also keeping tax liability to a minimum—is a smart strategy. Actively managed funds, for example, might be an appropriate choice, while something like an exchange-traded fund, which has less turnover and fewer taxable events, might be better suited to a taxable investment account.
Investments that are insulated against inflation are also something to consider with a Traditional IRA. Treasury Inflation-Protected Securities (TIPS) and bonds, for example, may be taxed at higher rates than stocks, making them a potentially attractive choice for a Traditional IRA. Just remember to keep your broader asset allocation in mind as you choose investments. Your IRA should be as tax-efficient as possible, but it should also reflect your risk tolerance and diversification goals.
Consider a Conversion
Unlike a Traditional IRA, a Roth IRA doesn’t allow you to deduct your contributions on your taxes. Instead, you can withdraw your savings tax-free in retirement. That can be a huge plus if you expect to be in a higher tax bracket once you retire. If that’s the case, you may want to think about converting your Traditional IRA to a Roth.
There is, however, a catch. When you convert a Traditional IRA, you’ll have to pay taxes on the money you contributed. That could push you into a higher tax bracket for that year. If you’re considering a Roth conversion, be sure to pay close attention to the timing. Aiming to execute a conversion in a year when you have more deductions or lower earnings can minimize the sting of paying taxes on your Traditional IRA savings.
Remember to Set Your Beneficiary
Traditional IRA assets aren’t taxed until you withdraw them, and technically, you don’t have to take any money out of your account until you reach age 70½. At that point, the required minimum distributions kick in. That same rule applies for any beneficiary who inherits your IRA.
If, for example, you’re married, you could name your spouse as your beneficiary. If you pass away before turning 70½, your spouse wouldn’t be obligated to take any money out of the IRA until he or she hit that same age milestone. Your spouse could roll the money over into a new IRA and name a beneficiary of his or her own, who would also be subject to the required minimum distribution rule.
Effectively, this allows you to stretch your IRA and make the money last longer. You could even divvy up your IRA among multiple beneficiaries to maximize it even further. The paperwork can be complicated, however, so be sure to check with a financial professional or tax expert beforehand to make sure you’re getting it right.