An Individual Retirement Account (IRA) is a great way to set aside money toward your retirement years, but if you don’t know the rules regarding these accounts, you can make some costly mistakes. Here are some common IRA mistakes people make and how to avoid them:
1. Forgetting to contribute
You’re making a costly financial mistake if you have set up an IRA but do not make contributions. Because you cannot contribute in past years, you are missing out on tax-deferred retirement savings. With time, IRA savings have greater potential to grow. People who contribute to their IRAs each and every year will have more money during their retirement years than people who have an IRA but skip contributing some years.
2. Overestimating your income
There are income limitations with IRAs that if you make too much money, you are not able to contribute to a Roth IRA. If your income is beyond the maximum limits allowed for contributing to Roth IRAs you don’t want to make the mistake of skipping the contribution all together – you want to put the money in a traditional IRA instead, and later convert it to a Roth. Almost anyone with income from a job or self-employment can contribute to a traditional IRA. While Roth IRA contributions are made with after-tax dollars and can be withdrawn tax-free during retirement, traditional IRA contributions are made with pre-tax dollars that may or may not qualify for a tax deduction the year you make the contribution – but are taxed when you take distributions during retirement.
3. Not taking required minimum distributions
Traditional IRAs require that people start taking a required minimum distribution starting at the age of 70 and ½ years. If you don’t take out enough money, you will end up paying penalties as high as 50% of your distribution.
Roth IRAs do not require minimum distributions while the account owner is alive, but when you pass away your beneficiary is required to take distributions based on their life expectancy if they want to stretch the money and tax advantage out through the end of their lifetime. For beneficiaries of traditional IRAs, there are still minimum distribution rules and the same 50% penalty if you don’t take out the required minimum.
4. Mucking IRA rollovers
Moving money from a 401(k) or a traditional IRA to a Roth IRA can cause expensive problems and is often time consuming to fix. Even if you pay a financial adviser to take care of moving the funds you could find yourself paying taxes on money you weren’t expecting to pay tax on and the only way to fix it is to work with the IRS – a process that costs money and can take as much as eight months.
5. Missing deadlines for rollovers
Let’s say you leave a job with a 401(k) that you want to move to an IRA. You have 60 days from the time you leave an employer to withdraw the money from your 401(k) and put it into a qualified retirement account without having to worry about tax consequences. If you don’t do it within the 60 day timeframe, you’ll end up paying taxes on the money and maybe even early withdrawal penalties.
To avoid the possibility of missing a deadline, you can do a direct transfer from your 401(k) to a retirement account and never receive the money yourself. The money is transferred directly, but you will need to make sure the new retirement account is set up correctly for this to work out.
You are also only allowed to do one rollover per year. If you rollover two accounts in the same 365 day period, you will pay fees and penalties.
Debbie is a writer who specializes in parental finances, consumer spending and mortgages.