You’ve got less than two weeks left to take action on one of the few tax moves you can still make now to get a break on your 2014 taxes: put money into an Individual Retirement Account. Or if you’ve already filed taxes and are getting a refund, consider putting some of that windfall into an IRA for 2015.
The biggest benefit of an IRA, which you can set up with just about any bank, brokerage of mutual fund, is the favorable tax treatment. In a traditional IRA you get a tax break now on the money you deposit, which then grows tax-free. A Roth IRA allows you to put in after-tax money now, but you won’t have to pay taxes on the withdrawals you make in retirement.
“Every opportunity should be taken to grow money tax-free or tax-deferred where possible,” says Lee Frush, a certified financial planner with Cornerstone Financial.
Related: 8 Smart Ways to Lower Your Taxes in Retirement
Beyond helping cut your tax bill, IRAs are a smart financial move for anyone serious about retirement planning. Still, while the accounts may be a favorite among financial planners, they’re less popular among the general public. A recent survey by TIAA-CREF found that few Americans place a priority on putting money into an IRA.
The survey found a lack of understanding of how an IRA can be an important component of any retirement plan. Among those in the poll who weren’t contributing to an IRA and said they wouldn’t use one as part of their retirement strategy, 39 percent admitted they don’t know enough about the accounts to consider one.
“Americans are missing out on the importance of an IRA because many don’t understand that they have investment options,” says Margie Shard, president and wealth advisor with Shard Financial Services in Fenton, Michigan. “They also don’t understand investing, so it’s easier to spend their money on vacation and appliances.”
Here’s what you need to know:
There are limits: For 2014 and 2015, individuals under age 50 can contribute $5,500 a year to an IRA. Those age 50-70 ½ can put in an extra $1,000 in. Everyone’s earnings grow tax-free, but your ability to deduct the contributions from your taxes depends on whether you have a retirement plan at work and your total income.
The IRA deduction for 2015 phases out for those with a workplace retirement account with incomes between $61,000 and $71,000 for single taxpayers, and between $98,000 and $118,000 for joint filers.
For Roth IRA contributions in 2015, the deduction phases out for single filers with adjusted gross income between $116,000 and $131,000, and for married couples with adjusted gross income of $183,000 to $193,000.
Related: Watch that Free Money for IRA Rollovers
You can contribute to both a 401(k) and an IRA: If you’ve got a workplace retirement plan like a 401(k), you may not be able to deduct your contributions, but if you’ve maxed out your 401(k), stashing extra retirement cash in an IRA account may still be worth it since your earnings there would be tax-deferred. More than 80 percent of households with an IRA in 2014 also had an employer-sponsored plan, according to the Investment Company Institute.
They’re more flexible than 401(k)s: Since you decide where to invest your money, IRAs offer far more options than 401(k) plans dictated by your company. Often investors — especially those making last-minute contributions for tax reasons — don’t take full advantage of those investments. A Vanguard report last year found that during tax season, investors tend to stash money in money market accounts, which have paltry returns. If you don’t have the time or inclination to research the best funds, consider putting your money into what’s known as a target-date fund, which will automatically diversify and rebalance the account for you over time.
Tapping them early can be costly: With a traditional IRA, taking money out before age 59 ½ will land you a 10 percent penalty, in addition to taxes on earnings for an early withdrawal. Protect yourself by building up an emergency fund with three to six months worth of expenses before putting all your savings into an IRA. That way you have cash you can access without consequence if an unexpected outlay pops up.
Related: The Worst States for Retirement in 2015
For those who are eligible, investing in a Roth IRA might be the better move if you don’t have an emergency fund. During the contribution phase, you can access what you have put into your Roth without penalty. “This is a nice feature for younger investors looking for liquidity in their investments,” says Mark Zoril, founder of PlanVision, which helps employers manage retirement plans.
Making withdrawals requires planning: Once you reach age 59 ½, you can take distributions from your IRA. By age 70 ½, you must withdraw the required minimum from your traditional IRA and 401(k) accounts each year or face penalties of 50 percent of the amount you failed to withdraw. Your required minimum distribution changes every year based on your life expectancy (according to the IRS) and account balance; usually your account provider will make the calculation for you.
You’ll owe income taxes on the withdrawals that you make, so it usually makes sense to take money out of taxable accounts on years when your income is lower, such as when you have a lot of deductions like medical expenses or charitable contributions.
You can convert from a traditional to a Roth, but it can be tricky: In some cases, it makes sense to convert an existing IRA into a Roth so that you can have tax-free income in retirement. There’s no income cap or limit on how much money investors can convert, but you must pay taxes on the amount converted and wait a minimum of five years before making a withdrawal in order to avoid a penalty.
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