Your individual retirement account is a tool that allows you to sock away money for your retirement without having to pay taxes on the deposited funds. Funding an IRA when you're young can have a significant impact on your wealth when you get older. For example, $2,000 saved at 9.75 percent -- which is the annual return of the stock market over a 100-year period from 1913 to 2012 -- turns into $5,071 after 10 years and grows to $29,700 after 30. With this in mind, it's usually in your interest to contribute 100 percent of what you can to your IRA.
IRA Contribution Maximums
Unlike workplace plans where you contribute a percentage of your salary, the amount that you can put into your IRA is a flat dollar amount defined by the Internal Revenue Service. Barring any additional limitations, you can put up to $5,500 into your IRA ($6,500 if you're over 50) in the 2013 tax year. Sometimes, the IRS changes the limit, so you may want to check which limit actually applies at any given time before making your contribution.
Your IRA contribution can be limited in a few instances. As of 2013, if you have an adjusted gross income of $59,000 or more if you're single or $95,000 or more if you're married, you might still be able to contribute to your IRA but might not be able to deduct it if you also have a retirement plan at work. If you're married and only one of you have access to a workplace plan, the threshold if $178,000. Also, the IRS generally makes you choose between contributing to a traditional tax-deferred IRA and a Roth IRA.
IRA vs. 401(k)
If you have access to a 401(k) at work and can't afford to fund both a 401(k) and an IRA, you may choose to fund your 401(k) first. One reason that you may choose to do this is if your employer offers a match. It's simple math that putting $2,000 of your own money into an IRA gives you less money than contributing $2,000 of your own money and $1,000 of your boss' money into a 401(k). 401(k)s are also automatic, eliminating the risk that you won't have the discipline to do it. Once you've maxed out the amount of money that your employer will match, you may want to consider other concerns -- like the quality and cost of funds in your 401(k) -- before deciding whether to fund your 401(k) or shift your money towards funding your own IRA.
IRA vs. Roth
The IRS generally gives you a choice as to whether you fund a traditional IRA or a Roth IRA -- you can put 100 percent of your limit in one or the other, or spread it between both. If you put $5,500 in a traditional IRA, since it's tax deductible, all of that $5,500 will work for you. With a Roth IRA, you pay federal and state income tax on the money you put in, so if you're subject to 15 percent federal and 5 percent state income tax, that $5,500 turns into $4,400 after taxes. However, when you pull the money out, you won't have to pay any tax on it as long as you wait at least five years and until you retire.
How to allocate your money between the two accounts varies greatly based on your current tax rate, your future tax rate and how you invest the money. For example, $5,500 placed in an IRA will grow to $142,732 after 35 years of growth at 9.75 percent, while $4,400 placed in a Roth will grow to $114,186. However, when you withdraw the funds from a Roth, you get to keep the entire amount. If your combined federal and state tax rates are 30 percent when you retire, you'd have to pay $42,820 in taxes on the money in the traditional IRA, giving you just $99,912.
If you can afford to fund your traditional or Roth IRA up to 100 percent of its limit, you'll be making the most of the opportunity to save for retirement with tax advantages. However, you'll also be locking up your money for a long time. Money that you put in a tax-deferred IRA can't ever be withdrawn without paying income tax and, if you withdraw before you're 59-1/2 and don't qualify for the IRS's waiver, will also be subject to a 10 percent penalty. You also have to start pulling it out when you turn 70.5 years old, whether or not you want to. With a Roth, you don't have to pull it out and can pull out the money that you contributed at any time, but your earnings are subject to the same limitations.
- MoneyChimp: Compound Annual Growth Rate (Annualized Return)
- CNN Money: How Much Should I Put into an IRA?
- IRS: Retirement Topics -- IRA Contribution Limits
- IRS: IRS Announces 2013 Pension Plan Limitations; Taxpayers May Contribute Up to $17,500 to Their 401(k) Plans in 2013
- Bankrate: Fund Your 401(k) or IRA First?
- Oprah.com: Nine Small Financial Steps That Will Pay Off Big in the Future
- RothIRA.com: Traditional IRA vs. Roth IRA
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.