Just Because You Can Contribute To An IRA Doesn't Mean You Should

I know, it sounds weird coming from a financial planner. We're supposed to tell you to save more, not the opposite. However, I'm not telling you not to save. It's just that an IRA isn't always the most ideal type of account to throw your retirement savings into.

The biggest reason to sidestep IRA contributions has to do with the tax code. If you're a single tax filer and you make more than $61,000 ($98,000 for married joint filers), your ability to deduct an IRA contribution starts to diminish. Once you reach $71,000 ($118,000 for joint filers) your deduction goes away completely. Those are 2016 numbers.

If you find yourself above those thresholds, it's in your best interest to at least explore other options.

The 401(k) Option

Most investors have access to a company 401(k), 403(b), 501(c) or 401(a) plan. Contributions to these plans are fully deductible regardless of your income level, which is a benefit not available for IRA contributions for investors above the income thresholds I just mentioned. Another benefit is many of these "employer sponsored" retirement plans include low cost Index Funds as investment options.

If you're fortunate to work for a company offering a matching contribution incentive, it's ok to contribute above the matching percentage. In fact, investors can defer up to $18,000 of their salary. For seasoned investors over age 50, the limit stretches to $24,000.

The Roth IRA Play

Individual investors making up to $117,000 ($184,000 for joint filers) have the option of contributing to a Roth IRA. Most of us know that distributions from Roth IRAs are handed out tax free. This is pretty powerful.

Here's why.

If an investor with a starting balance of $100,000 in their IRA continued to make deductible contributions of $6,500 per year from age 50 through age 65, they'd have $403,724 after 15 years*. If those contributions were instead directed to a Roth IRA, they'd still have the same $403,724 balance sitting in the Roth. However, the IRA dollars will be taxed when the investor takes distributions. Not so in the Roth. For an IRA investor in the 28% tax bracket, they don't really have $403,724 as their brokerage statement suggests.

Astute investors might call me out with the argument that the IRA investor might have been able to deduct IRA contributions. True. But, if you're eligible to deduct IRA contributions it means you're in the 25% tax bracket or lower, and one year's worth of IRA contribution deductions is only going to save you $1,625 at most. Extrapolate that savings over 15 years and you're still only at $24,375, not even a quarter of the tax savings you'd experience had you utilized the Roth IRA.

Other Accounts That Might Work

Business owners, 1099 contractors, and highly compensated employees may have some unique account cards to play. Business owners and 1099 contractors may be eligible for an Individual 401(k), SIMPLE IRA, or SEP IRA. Highly compensated employees may have access to a Deferred Compensation Plan. All of these account structures provide the ability to deduct contributions whereas those same contributions may not enjoy the same deductibility if they occur in an IRA.

So how do you know what accounts are available to you and which you should choose? This is part of Comprehensive Financial Planning, so paying for a plan to explore your options is probably a good idea. Additionally, many tax advisors can provide guidance. However, tax advisors generally try to impress with how much money they can immediately save you; they want you to hire them each year! Because of this inherent conflict, they may steer you away from an account that serves you best in the long run (the Roth IRA) in favor of an account to better serve you in the short term. If you hire someone, make sure they show you the now vs. later comparison regarding their recommendation.

The lesson with all this is it's not enough to simply commit to saving $$$ for your future. While it's important to be saving enough, saving enough in the most appropriate account structures is what smart investors investigate prior to making contributions. If you want a recommendation based on your personal situation, let's chat. Use the Shoot Us An Email fields in the footer at the bottom of this page.

* Assumes a 6% return compounded monthly.