Avoid these 7 common IRA mistakes
IRAs are supposed to be easy. And generally speaking, they are.
The government created Individual Retirement Accounts, or IRAs, to encourage people to save more for their retirement and provided tax benefits to make them more attractive.
It also made them fairly simple to open. You can usually download the forms from a financial institution, set up an automatic transfer from your bank and be up and running in a few minutes. In addition, everyone from big mutual fund companies like Vanguard or Fidelity to your local bank will offer you investment options for your IRA.
But with all this convenience, avoiding a few key mistakes is still critical to making sure your IRA is building the wealth you’ll need for retirement. Knowing the rules and the way IRAs can affect your taxes and other government benefits are all essential. Here are 7 common errors financial professionals frequently see — and how to avoid them.
1. Delaying the decision
If you feel like you’ve heard this a thousand times, it’s because it’s so important: If you haven’t already opened an IRA, the day to get started saving for retirement is today.
Not only will your savings have more time to grow, but you’ll put less stress on your monthly budget by setting a reasonable amount aside now, rather than trying to catch up at the end. You’ll also enjoy more years of tax deductions for a traditional IRA.
“It sounds obvious, but the biggest mistake with retirement saving is just simply not getting started. You procrastinate; you’re not ready to think about it, so you put things off,” says Bill Pratt, a professor of finance at Virginia’s Piedmont Community College who is part of The Money Professors, a group of academic financial experts whose mission is to educate the public on personal finance.
2. Not knowing what’s in your IRA
An IRA is a kind of account, not a particular financial instrument like a savings bond or a certificate of deposit.
“People don’t understand that ‘IRA’ is nothing more than a label slapped on an investment,” says Piedmont Community College’s Bill Pratt. “It’s not a product; it’s simply a classification that says the government won’t tax this like they do other stuff if you follow certain rules.”
Many different investments can qualify for an IRA: mutual funds, CDs, stocks and bonds, even some real estate.
But Pratt says he is surprised by how often people tell him they have an IRA, yet don’t know what’s in it.
You need to know. Investments with a higher upside but greater risk like stocks make sense early on. Later, you’ll want to be more conservative. It doesn’t have to be hard: Mutual fund companies offer funds that automatically adjust the mix of investments based on age.
3. Not knowing your contribution limits
You’re doing a little better than you thought, or you get a one-time windfall, and you decide you’re going to stick a little more into your IRA. It’s a great idea — up to a point.
Before age 50, the government says you can contribute $5,500 annually to your IRAs. After 50, the ceiling goes to $6,500 to help you catch up, if necessary. (Those limits may be adjusted annually for inflation.)
Those are total limits for all your personal IRAs. Some people set up more than one IRA, often a traditional IRA, in which contributions up to the limit are tax-deductible, and a Roth IRA, where contributions aren’t deductible but later withdrawals are tax-free.
Diane Pearson, a certified financial planner with Legend Financial Advisors in Pittsburgh, notes it’s important to make sure your contributions don’t exceed the limits, but also to be aware of the catch-up provisions if you need to start saving more.
4. Getting blindsided by a withdrawal penalty
IRAs can be tempting to draw on for big purchases, emergencies or to help out a family member. But until you reach 59 ½, only certain withdrawals are allowed without penalty for a traditional IRA. (You can withdraw from a Roth IRA without penalty.)
“Probably the biggest mistake is taking money out of an IRA as an early distribution without realizing just how much it’s going to cost in taxes and penalties,” says Erin Baehr, a certified financial planner who heads Baehr Family Financial in Stroudsburg, Pennsylvania. “If you’re in the 25% bracket and you have a penalty, it’s going to be a huge hit.”
You should check with the IRS or a tax professional if you’re uncertain, but in general you can take money out without penalty for deductible medical expenses, college costs and a first-time home purchase. Otherwise, you’re going to get hit with taxes and a 10% IRS penalty.
5. Failing to take minimum distributions
This may seem like an unlikely problem: Who’s really going to forget to tap their IRA when they retire? Yet many of us end up working longer than we expected, and some retirees are lucky enough to find they don’t need all the money they thought they would once they stop working.
But as far as the government is concerned, there’s a time when you have to start taking withdrawals from a traditional IRA. Generally, it’s age 70 ½, although Roth IRAs don’t require withdrawals until after the death of the owner.
Your minimum distribution depends on how much you have in the account. The IRS has a worksheet; to figure the amount.
Certified Financial Planner Diane Pearson notes there can be a 50% penalty on the amount not distributed. “Generally, the IRS has been lenient if you make a one-time goof,” she says. But it’s best to avoid the mistake altogether.
6. Forgetting about Medicare
One challenge in retirement planning is that several things that don’t seem like they’d be related are interconnected. Medicare Part B is additional Medicare coverage for which you pay a modest premium. For most Americans that is $104.50 for 2014. But if your income jumps above certain levels — $85,000 in adjusted gross income for single taxpayers — your premium increases.
“It mostly happens for single people,” says Certified Financial Planner Erin Baehr. “Say you take $20,000 out (of an IRA) to help your child buy a house, and you go over the income limit by even a hundred dollars, you’re premium is going up.”
The premiums for Medicare Part D, which provides drug benefits, also depend on income, although they’re smaller overall. The thing to remember is that you need to examine the consequences of any large withdrawal of money that’s going to change your income in the eyes of Uncle Sam.
7. Messing up the details
There’s not a lot of paperwork with an IRA, but it’s still your responsibility to see that it’s done right.
Certified financial planner Diane Pearson has seen family members lose benefits because the form designating a beneficiary for an IRA in the event of death was filled out improperly.
“Failure to properly check the details can come back to haunt you,” Pearson says. “When in doubt, consult a professional, but don’t be afraid to check their work.”
She has also seen transfers from other retirement accounts, known as rollovers, go wrong because the transfer was improperly handled by the receiving financial institution.
“We see these cases all the time. We find out the money never got to the IRA,” she says, which can lead to penalties. “If it happens, the participant actually has to go to the IRS and ask for relief.”
The lesson: Make sure all the blanks are filled and the boxes checked.