Because individual retirement accounts have become so common, Americans are making some common mistakes.
Many IRA investors are losing track of the year for which contributions were made, resulting in a double contribution or a missed one.
Some people still aren`t aware that, at many financial institutions, they can put as little as $25 into an IRA at a time. Or they don`t know that many institutions permit them to borrow money to fund their contribution and that they can deduct the loan interest on their taxes.
Other investors just don`t keep up on changes. Starting with the 1985 tax year, for example, any divorced spouse receiving alimony but not holding a job is permitted to make a regular IRA contribution. That`s because alimony is now considered earned income.
Keep all the basics in mind to avoid making the usual mistakes:
— The timing of your IRA contribution can make a big difference. While you`re required only to make your contribution by April 15 of the following year, the sooner you shelter the money, the better.
Let`s say that an investor named Joan makes her $2,000 annual IRA contribution at the beginning of each tax year, while her friend Michael always makes his contribution in April of the following year.
At the end of five years, assuming a 9 percent return compounded monthly, Joan will have $13,192, while Michael will have only $9,838. At the end of 40 years, Joan will have $818,777, versus Michael`s $730,008. That`s a difference of $88,769 at retirement.
— Pay attention to details. For example, most everyone knows that anyone under 70 1/2 years of age who has income from a job or alimony is eligible to open an IRA, and that an individual can contribute up to $2,000 a year. That`s $4,000 for two-income families, or $2,250 for one-earner families.
However, many investors mistakenly think that in spousal accounts you must deposit $2,000 to the working spouse and $250 to the nonworking spouse. Actually, spousal IRAs can be divided between the two any way you wish, provided no one gets more than $2,000. Some advisers suggest giving the larger amount to the wife, since her life expectancy is greater.
— Don`t feel you must keep your IRA money where you put it first. There are several ways of moving it if you`re unhappy. The first, an IRA rollover, switches funds from one IRA to another as you, the investor, take possession of the money. There are no penalties if you complete the switch in 60 days, but you can only make one move a year.
The second way, a transfer, is the automatic switching of IRA funds from one institution to another or from one investment vehicle to another. You never touch the money. It can be done as often as you like, but watch out for institutions slapping penalties and handling fees on transactions.
— It`s not the end of the world if you must withdraw money early.
The fact that there`s a penalty of 10 percent on funds withdrawn before age 59 1/2 and that the money is taxed as ordinary income definitely means a withdrawal after only a year or two will hurt. But studies have shown that, after several years, you`ll likely still wind up better off having invested in an IRA–even after paying the early withdrawal penalties–than had you kept that money in a similar taxable investment.
— Understand how IRAs are handled upon the death of the investor. If that investor has named a beneficiary, the IRA will go to him or her in whatever manner has been designated. If the beneficiary is a spouse, he or she may roll it over into another IRA to maintain its tax-deferred status. If no beneficiary is named, the IRA becomes part of the estate.
— Don`t fret that tax law changes will damage IRAs. Under the tax reform bill passed by the U.S. House, IRA contribution levels would remain the same. The potential change is that, if an individual contributes to his company`s 401(k) income deferral plan, the maximum allowable IRA contribution would be reduced, beginning in 1986, dollar for dollar by the amount contributed to that 401(k) plan. In addition, the penalty for early withdrawals would be increased to 15 percent.
