Common IRA Pitfalls to Avoid: Protect Your Retirement Savings

By Dumb Little Man

January 10, 2024

An Individual Retirement Account (IRA) is a good savings option since it offers various accounts to fit a retiree’s needs. Retirees can only save up to $6,500 in their IRA. But they can make another $1,000 “catch-up” contribution if they’re over 50. 

This limit will bump to $7,000 next year. The catch-up contribution will stay at $1,000 more. Also, the catch-up amount will automatically go up with inflation each year. It means $1,000 will adjust slightly over time to keep up with rising prices.

Understanding IRA contribution limits is crucial, but comprehending the broader scope of IRAs is equally vital. Here are common mistakes traditional and Roth IRA holders often make and tips for avoiding them.

Making Last-Minute Contributions 

Investors have until the tax-filing deadline, usually April 15, to make IRA contributions for the preceding year.  Surprisingly, many investors tend to wait until the last minute. They pay near the deadline instead of utilizing the whole contribution period from January 1 of the previous year. 

These eleventh-hour contributions have less time to grow, even if it’s just a difference of 15 months. This action can significantly impact the accumulated funds over time.

Pay your contributions on time to avoid issues. You can use an online IRA calculator to calculate your IRA and corresponding tax inputs. 

For those who are unable to contribute the total amount upfront, establishing an auto-investment plan with their IRAs is smarter. They can ensure consistent contributions by investing in fixed installments monthly until they reach the limit. They can also maximize the time for their investments to grow.

Designating the Wrong Beneficiary 

The transfer of an IRA goes through the named beneficiary rather than via a will. It emphasizes the importance of choosing the appropriate beneficiary while you’re alive. 

There are cases wherein the widow discovered that her deceased husband had left his IRA to his ex-wife. This situation happened because he hadn’t updated the beneficiary designation. This spurred the widow to pursue legal action. 

Regularly review your beneficiary designations to prevent such scenarios. Make sure they’re current and accurately represent your present circumstances. Setting reminders on significant dates like birthdays or the start of a new year can help you remember to revisit these designations. It’s not just IRAs; other accounts like 401(k)s also have beneficiary designations that need attention.

If you have a family, you can designate your children as contingent beneficiaries while your spouse is the primary, dividing the assets equally to prevent potential conflicts.

In some instances, using a trust as the IRA beneficiary can be advantageous, offering protection against creditors. It can also protect the trust from marital issues, ensuring financial stability for a less financially secure child. It’s also beneficial to take a comprehensive approach. Consider family dynamics and involve an investment manager, estate attorney, and accountant in crafting a well-thought-out beneficiary plan. Regardless of the circumstances, choosing the proper beneficiary today is wise.

Thinking That Traditional and Roth IRAs Are the Same

There are various IRA options available to savers—the Roth IRA and the traditional IRA. Each comes with distinct features. As mentioned, the maximum contribution across all IRAs is $6,500 per person (or $7,500 for those aged 50 or older).

You have flexibility in allocating contributions between these accounts. For example, you can save $3,000 under a regular IRA and $3,500 in your Roth IRA. You can also save the entire $6,500 under a Roth. In a traditional IRA, contributions similar to a 401(k)  are tax-deductible, provided your income meets specific parameters.  This unique structure allows for tax-free withdrawals, including gains accrued over time.

Forgetting Your After-Tax Contributions

When you put money into a traditional IRA, you have to choose if it will be pre-tax or post-tax money. Pre-tax means the money you put in lowers your taxes now. Then again, you’ll have to pay taxes when you take them out later.

Post-tax money isn’t deducted from your taxes now. However, only the interest of your investment will be taxed once you withdraw it.  You will mix things up if you don’t remember which money is pre-tax and post-tax in your IRA. The IRA might levy taxes on your after-tax money when you withdraw it when they should only tax your earnings.

In short, when you put money in a traditional IRA, you must pick whether it’s pre-tax or post-tax. When you take it out later, knowing which it is helps you avoid getting taxed twice on the same money.

If you’ve made after-tax contributions to a traditional IRA, you should file Form 8606 to keep track of that. This form is crucial, especially if you’re considering Roth conversions.Sometimes, when people switch accountants or do their taxes themselves, they might accidentally contribute more than allowed to their Roth IRA. Or they need to remember to fill out a form. That’s an easy mistake to make if you’re not aware of the rules. But don’t worry, you can fix it. Just file an updated tax return using Form 8606. A tax professional can help you with the updated forms. They’ll know how to fix it so you don’t get in trouble with the IRS.

Believing That Contributing to a Roth IRA Is the Best Option

While there’s frequent praise for the benefits of Roth IRAs—no taxes upon withdrawal, tax-free growth, and no mandatory withdrawals in retirement—it’s inaccurate to assume that funding a Roth IRA is universally the optimal choice.

Going for a traditional deductible IRA might be smarter for investors who can deduct their traditional IRA contribution from their taxes. This is especially true if their income is below certain limits and they have yet to save much for retirementWhy? Because their tax rate during retirement might be lower than when they put the money in. This move makes the tax break more valuable for them now.

Unsure Where To Contribute

Consider your current taxes versus what you might pay in retirement if you decide whether to pick a Roth or traditional IRA. 

If you’re stuck, a good idea is to divide what you want to save in half. Put half in a traditional IRA for a tax break now, but remember you’ll pay taxes later on that part of your savings. Since you already paid the taxes upfront for the other part, you won’t owe anything when withdrawing during retirement.  That way, you hedge your bets for tax rates in the future while still getting the benefits of both types of accounts now.

Not Earning Enough To Contribute

If you didn’t make much money in a year, you can’t put more into a Roth IRA than you earned. It includes money from jobs, like wages, tips, or salaries.

You can also use earnings from: 

  • Commissions
  • Money from your own business
  • Military pay that isn’t taxed
  • Alimony or separate payments after a split

If you and your spouse file taxes together and one earns enough, you can save in a Roth IRA, following the allowed limits.

1. Not Paying Attention To Different Investment Options

Not paying attention to how you invest your IRA savings can affect how much money you’ll have in the future. Leaving money in cash or picking risky investments might not grow your savings well.

IRA is also more flexible and lenient. You can move your money if you don’t like where it is currently invested.  Work with a financial institution with resources to help you pick investments that match what you want for your retirement. Consider how much risk you’re okay with or when you plan to retire.

2. Disregarding the Catch-up Contribution

People aged 50 and below might not be considering retiring soon. They can save $1,000 more in their IRA accounts.  This means $15,000 more in retirement savings for someone who retires at 65. This catch-up contribution can help boost your savings if you’re behind on your financial goal.  

3. Only Making Long-Term Nondeductible IRA Contributions

If your earnings are too high to directly contribute to a Roth IRA, then it’s also too high to deduct traditional IRA contributions from your taxes.  The income limits are the same for both.The only savings option for most people is a regular IRA. While withdrawing, taxes are applicable, and despite its initial appeal, there are downsides to consider.

Investing in a nondeductible IRA is like a stepping stone to a Roth IRA. This method is called the “backdoor Roth” maneuver. You simply put money into the nondeductible IRA and then change it to a Roth IRA. 

4. Not Paying Contributions for Your Spouse

You can only save in an IRA up to what you earn yearly. However, you must follow a special rule for spouses who don’t work if you’re married and file joint taxes. Although there’s no “joint IRA,” a working spouse can contribute to their account and one for the non-working spouse. The working spouse must earn enough to cover both contributions.

It’s a smart move that could double your yearly savings and make a big difference in how much your family has for retirement.

5. Believing a Backdoor Roth IRA Is Completely Tax-Free

People often believe they won’t pay taxes for a backdoor Roth IRA. They think this because the money they put in has already been taxed. They also believe that if they change it to a Roth soon after, there might not be extra money made from investments.

This maneuver might be partly or primarily taxable because of the “pro rata rule.” This is especially true for those with a lot of untaxed money in a traditional IRA. 

6. Withdrawing Your Earnings Too Soon

Withdrawing from your Roth IRA can be tricky. You can withdraw anytime, regardless of age, because that money was already taxed when you earned it. But you might have to pay taxes and fines if you withdraw your investment earnings too soon. 

You must be 59½ years old and have had the account for five years to avoid these penalties.  If you’re under 59½, there are some cases where you won’t have to pay the fine for taking money out early. 

You’ll have to withdraw all the Roth IRA money within ten years if you inherit it from someone other than your spouse. Beneficiaries used to withdraw the money within their lifetime, but the new rule set an earlier withdrawal.

7. Not Paying IRA Later in Life

The rules for contributing to IRAs have changed as people work longer.  There’s no age limit for putting money into a traditional and a Roth IRA. The only condition is to earn enough money from working to cover your contributions. 

This income should not be from Social Security or other sources.  It’s wise to contribute to a Roth IRA later in life if you plan to leave money to your heirs instead of using it for retirement.  Your heirs can use the money tax-free. That’s because Roth IRAs don’t have required minimum distributions (RMDs). It makes the account attractive for older adults. 

8. Not Observing the Rollover Rule

Before 2015, you could only roll over once a year. Now, the government prohibits doing more than one rollover within 365 days. The rule applies even if the rollover spans two different calendar years.

You should follow this rule because making too many rollovers can lead to a huge tax bill. Some people even lost their entire IRA without realizing it by doing two rollovers in a year. The good news is there are leeways. First, you can move money from your traditional IRA account to a Roth IRA within 60 days. Second, you can directly transfer funds between two IRA trustees. 

9. You Initiate the Rollover

Here’s how to move IRA money from one retirement account to another:

  • Direct Rollover: The money moves electronically or via a check directly to the new account.
  • Indirect Rollover: You get the money from the old account and move it to the new one yourself.

It’s safer to go for the direct method. Things can quickly go wrong if you choose the indirect route. The most common mistake is missing the 60-day deadline to complete the transfer. People sometimes use the cash for something else and can’t put it all back in time.

10. Working With the Wrong Financial Advisor

Team with a financial advisor trained in retirement account tax laws. Retirement planning is tricky, and having an IRA specialist is crucial. It’s a personal journey, and mistakes can trip you up. A financial pro who stays up-to-date can help cut risks and preserve more of your retirement money for you and your loved ones.

Protect Your Retirement Savings by Being Vigilant 

Millions rely on traditional and Roth IRAs for retirement savings, yet only some fully grasp how they operate. Unfortunately, this lack of understanding leads to errors and missed chances. You must do your share by carefully studying the programs and their implementing rules. 

This information can help you dodge these common mistakes and maximize your IRA investments. If you can’t manage your retirement savings, seeking professional advice is never wrong. It’s best to ask for help now rather than suffer the consequences later. 

Dumb Little Man

At Dumb Little Man, we strive to provide quality content with accuracy for our readers. We bring you the most up-to-date news and our articles are fact-checked before publishing.

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