Money Girl covers 10 retirement account mistakes that could end up hurting your finances and how to easily avoid them.
One of the best ways to make sure you have a happy financial future is to get in the habit of setting aside money every month in a tax-advantaged retirement account. But with all the rules and regulations that come with these accounts, you may be worried that you’ll slip up and make a costly mistake.
In this 2-part series, you’ll learn 10 retirement account mistakes that could end up hurting your finances and how to easily avoid them. We’ll cover IRAs in this episode and then workplace accounts in Part 2.
What Is an Individual Retirement Arrangement (IRA)
One of the easiest ways to start putting money aside for retirement is to open up and contribute to an Individual Retirement Arrangement or IRA. These accounts allow you to set aside money with some nice tax savings.
The great thing about an IRA is that you control it, not an employer. It’s available to just about anyone who has earned income, even minors. For 2013 and 2014, you can contribute up to $5,500 or up to $6,500 if you’re age 50 or older.
Once you have money in an IRA, you can invest it, put it in a bank CD, or even keep it in a savings account. There are 2 main types of IRAs: traditional and Roth.
With a traditional IRA, you get a tax deduction for your contributions each year. In other words, the income you set aside isn’t taxed. Plus, you don’t pay tax on the earnings and growth in the account, until you withdraw money in retirement.
With a Roth IRA you don’t get a tax deduction for your contributions—they’re taxed before going into the account. However, the earnings and growth in the account are never taxed, even when you take withdrawals in retirement. Note that there are annual income limits that you can’t exceed in order to make Roth contributions.
No matter if you choose a traditional or Roth IRA, the tax benefits can turbo-charge your savings more quickly than if your money was in a taxable brokerage firm account. The more you contribute each year, the more you’ll benefit from the tax savings and make progress toward your retirement goals.
5 IRA Mistakes to Avoid
Now that you know the IRA basics, here are 5 costly mistakes you should avoid:
Mistake #1: Making an Early Withdrawal
Remember that a retirement account is designed for retirement. That means you’re not supposed to touch it until you reach the official retirement age of 59½!
If you make a withdrawal from your traditional IRA before retirement, not only will you have to pay taxes on the amount, but typically also a steep 10% early withdrawal penalty.
A Roth IRA allows you to withdraw contributions because they were previously taxed. But if you withdraw earnings before retirement, they will be subject to tax and a 10% penalty.
If you’re married and file a joint tax return, you and your spouse can both contribute to an IRA—even if only one of you has earned income.
Mistake #2: Assuming You Can’t Contribute
I mentioned that you must have earned income to be eligible to make an IRA contribution. But there’s an important exception to that rule that many people miss.
If you’re married and file a joint tax return, you and your spouse can both contribute to an IRA—even if only one of you has earned income. This is great news for anyone who might be a stay-at-home parent or temporarily unemployed.
The total contributions to your IRA and to your spouse’s may not exceed your joint taxable income or the annual contribution limits, whichever is less. For 2013 and 2014, that means you could both max out IRAs as long as you earn at least $11,000 ($5,500 + $5,500), or $13,000 ($6,500 + $6,500) if you’re both over age 50.