Maximize Your Traditional or Roth IRA

Two main types of individual retirement accounts (IRAs) are available to you, and whether you choose a traditional IRA or a Roth IRA (or some combination of the two), you’ll be getting a tax-advantaged way to invest your money long-term. But there are certain IRA investment strategies that can really boost your retirement savings.

How Does an IRA Work?

If you’re self-employed or a small business owner, either type of IRA is a great way to save money toward your retirement. Both types of IRAs offer tax breaks, but each does so in a different way:

• With a traditional IRA, you won’t have to pay taxes on your contributions, but you will have to when you withdraw this money.
• A Roth IRA is the opposite—you’ve already paid taxes on the money that you contribute, so you won’t have to pay taxes when you withdraw it in retirement.

In either case, you can invest up to $6,500 of your earned income in 2023 and $7,000 in 2024, plus another $1,000 if you’re age 50 or older in both years. You can have more than one IRA, but those are the limits for one or more.

There’s one big difference:

• The traditional IRA gets you an immediate tax break, meaning that the amount that you put in is deducted from your gross taxable earnings for the year. You’ll only owe taxes after you retire and begin taking out the money.
• The Roth IRA doesn’t get you an immediate tax break. You pay the income taxes on that money that year. But the entire balance will be tax-free when you start taking it out after retiring.

There are different limits for a couple with one spouse who does not have earned income. The spouse with earnings can contribute to a spousal IRA on the other’s behalf. To do so, you must be married and file jointly. This works with either a traditional or a Roth IRA.

How Traditional IRAs Work

A traditional IRA grows tax deferred. That is, you’ll pay no taxes on the money over the years when you build the fund. However, you’ll pay ordinary income tax on the entire balance as you withdraw funds.

You must start taking required minimum distributions (RMDs) by age 73 if you were born between 1951 and 1959 or by age 75 if you were born in 1960 or after. The age for RMDs used to be 70½ but was raised to 72 with the passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act in Dec. 2019 and increased again to the current age in Dec. 2022 with the passage of SECURE 2.0.

One note on the tax deduction with the traditional IRA: You can deduct your entire contribution for the year, up to the limit, if neither you nor your spouse has a 401(k) or another retirement plan at work. If either one of you is covered by a plan, then the deduction may be reduced or eliminated.

How Roth IRAs Work

As noted, with a Roth IRA, you don’t get an up-front tax break for the money that you contribute. But withdrawals are tax-free if you’re age 59½ or older and the account has been open for at least five years.

There are no RMDs. You’ve already paid the taxes due, so the Internal Revenue Service (IRS) doesn’t care when or whether you take your money out. You can even leave it for your heirs as a tax-free inheritance.

Roth IRAs are subject to income limits for eligibility. If you earn too much, then your eligibility is limited or eliminated. The income limits are adjusted from year to year:

• For 2023, the range is $138,000 to $153,000 for a single filer and $218,000 to $228,000 for a married couple filing jointly.
• For 2024, the range is $146,000 to $161,000 for a single filer and $230,000 to $240,000 for a married couple filing jointly.

Strategies to Manage Your IRA

Whichever type of IRA you choose (and you can have both), you can boost your nest egg by following some simple strategies.

1. Start Early

Compounding has a snowball effect, especially when it’s tax-deferred or tax-free. Your investment returns are reinvested and generate more returns, which are reinvested, and so on. The longer money has to compound, the larger your IRA balance will get.

Don’t be discouraged if you can’t contribute the maximum amount in any given year. Invest in whatever you can. Even small contributions can expand your nest egg substantially, given enough time.

2. Don’t Wait Until Tax Day

Many people contribute to their IRAs when they file their taxes, typically on April 15 of the following year. When you wait, you deny your contribution the chance to grow for up to 15 months. You also risk making the entire investment at a high point in the market.

Making your contribution at the start of the tax year allows it to compound for a longer period. Alternatively, making small monthly contributions is easier on your budget and still gets you to the right place.

If you hold stocks in your IRA, it’s a good idea to make equal monthly contributions throughout the tax year. This strategy is known as dollar-cost averaging (DCA). It takes the guesswork out of market timing and helps you develop a disciplined approach to saving for retirement.

3. Think About Your Entire Portfolio

Your IRA might be just part of the money that you’re setting aside for the future. Some of that money may be in regular, taxable accounts. Financial advisors often recommend distributing investments across accounts based on how they’ll be taxed.

Usually, this means that bonds—whose dividends are taxed as ordinary income—are best bought for IRAs to postpone the tax bill. Stocks that generate capital gains are taxed at lower rates, so they are better used in taxable accounts.

But in practice, it isn’t always that simple. For example, an actively managed mutual fund, which may create a lot of taxable capital gains distributions, might do better in an IRA. Passively managed index funds, which are likely to produce much lower capital gains distributions, might be fine in a taxable account.

If the bulk of your retirement savings is in an employer-sponsored plan, such as a 401(k), and it’s invested relatively conservatively, you might use your IRA to be more adventurous. It could provide an opportunity to diversify into small-cap stocks, emerging foreign markets, real estate, or other types of specialized funds.

4. Consider Investing in Individual Stocks

Mutual funds are popular IRA investments because they’re easy and offer diversification. Still, they track specific benchmarks and often do little better than the averages.

There may be a way to get higher returns on your retirement investments if you have the expertise and time to pick individual stocks.

Investing in individual stocks takes more research, but it can yield higher returns for your portfolio. In general, individual stocks can give you more control, lower management fees, and greater tax efficiency.

5. Consider Converting to a Roth IRA

For some taxpayers, it may be advantageous to convert an existing traditional IRA to a Roth IRA. A Roth account often makes more sense if you’re likely to be in a higher tax bracket in retirement than you are now.

There are no limits on how much money you can convert from a traditional IRA to a Roth. Also, there are no income eligibility limits for a Roth conversion. In effect, these rules allow people who make too much money to contribute to a Roth IRA directly to fund one, by rolling over a traditional IRA.

There are costs involved. You’ll have to pay income tax on that money in the year when you convert it to a Roth. And it could be substantial, so look at the numbers before you make any decisions.

Here’s a quick example: Say you’re in the 22% marginal tax bracket, and you want to convert a $50,000 traditional IRA. You would owe at least $11,000 in taxes. On the other hand, you’ll owe no tax when you take money out of your Roth IRA in the future. And that includes any money that your investments earn.

It basically comes down to whether it makes more sense to take the tax hit now or later. The longer your time horizon, the more advantageous a conversion could be. That’s because the new Roth account’s earnings, which are now tax-free, will have more years to compound. And you won’t have to worry about the five-year rule.

6. Name a Beneficiary

If you don’t name a beneficiary, then the proceeds of your retirement account could be subject to probate fees and vulnerable to any creditors that you have. Also, its tax-deferred compounding will be cut short.

Adding a beneficiary not only avoids these problems, but if the beneficiary is a spouse, someone permanently disabled, someone chronically ill, or someone not more than 10 years younger than the account owner, it also can allow the heir to stretch out the tax deferral by taking distributions over their lifetime rather than as a lump-sum payment. An individual beneficiary or non-person entity that inherits the IRA must cash out the full amount within 10 years, as per the new SECURE Act.

A spouse can opt to roll over your IRA into a new account and won’t have to begin taking distributions until their required RMD age. Then your spouse can leave the account to another beneficiary, which recalibrates the distribution requirement.

If you want to name more than one beneficiary, simply divide your IRA into separate accounts, one for each person.

There are separate beneficiary rules, depending on the type of IRA that you leave to your heirs. Check with your financial advisor to make sure that you’re using the most tax-efficient tax strategy.

The Bottom Line

Both traditional and Roth IRAs offer a great way to save for retirement, and both offer tax advantages. These tax advantages are why the IRS imposes limits on the amount that you can contribute to your IRAs per year. In 2023, this limit is $6,500 for people under 50 years old and $7,500 for those 50 and older. In 2024, it is $7,000 and $8,000, respectively.

You should try to contribute the maximum that you can to your IRAs, as long as this doesn’t leave you short for everyday expenses. Putting money into an IRA early gives it the maximum possible time to grow. Even if you can’t reach the contribution limits, you should contribute what you can to start building a fund for retirement.