We often get the question, “Should I Maximize My IRA Contributions?” The answer is usually a simple one – yes, you should! IRAs are fantastic tools to save for retirement with a generous combination of tax advantages that can help you keep taxes low at every stage in your life. Now, those are all nice words and phrases, but you, as an investor and retirement planner, probably want more than that. In this article, we’ll review some key reasons you should consider maximizing your IRA contributions and perhaps some times when you should reconsider.
First, let’s go over IRA contribution limits.
And a quick notification – these are 2023 numbers because we want to clarify that you still have time to contribute to your IRA before the April 15th deadline. The same concepts apply to 2024, though there are different contribution limits and phase-outs.
For tax year 2023, you can contribute $6,500 to your Traditional or Roth IRA (or a combination not exceeding $6,500). If you’re age 50 or older, you can contribute an extra $1,000.
But should you actually contribute that much?
Of course, the real answer is IT DEPENDS.
But the simplest of answers is yes, you should, if only for the simple fact that so many Americans don’t save up for retirement at all, and if you at least maximize your IRA contributions (and invest them!), you’ll be better off than if you had done nothing. Yes, there will likely be Social Security benefits in retirement, but are those enough to really enjoy retirement? You likely won’t be getting a pension, either. You should depend on yourself for retirement, and the IRA is one of the best tools to prepare for it.
Plus, by maximizing your retirement contributions each year, you’ll hopefully feel fewer financial concerns as you watch your savings consistently grow over the years and decades. It will also help reinforce the habit of investing, and hopefully, you’ll eventually expand beyond your IRA contributions to other forms of investing, such as utilizing a traditional brokerage account.
But perhaps those reasons are too vague and fuzzy for you to decide whether or not to maximize your IRA annual contributions. Here are some more concrete and potentially timely decisions:
Reduce Your Taxable Income
Contributions to a Traditional IRA are tax-deferred and deductible, meaning you get an immediate tax break for the amount you contribute. So if your salary is $96,000 in 2023 and you contribute $6,500, your taxable income is now only $89,500, and, all other factors being equal, you’ve dropped a tax bracket from 24% to 22% – assuming you’re a single filer and aren’t covered by a workplace retirement plan. That last point is significant, but we’ll get back to that later.
Tax-Deferred Growth via Traditional Contributions
Typically, whenever you sell an asset or receive a dividend, you’ll owe taxes on any gains you get. By taking those gains in a retirement account, you avoid paying taxes on them until you retire, and you’ll have more money each year to reinvest, quickening the compound effect of your growth. Of course, taxes on decades of growth once you retire don’t sound too appealing, but they are supposedly offset by the deductions you claimed throughout your contribution years and by being in a lower tax bracket in retirement – again, supposedly.
Tax-Free Growth via Roth Contributions
Maximizing or contributing to the Roth IRA doesn’t bring immediate tax benefits like traditional deductible contributions. However, your gains and withdrawals will be tax-free, simplifying your tax strategy in retirement and allowing your gains to grow unheeded by any Required Minimum Distributions that Traditional IRAs are burdened with.
Why Not Both?
Combining the above strategies so you can reduce your tax bracket now and have tax-free income later is often the key to a tax-savvy contribution and withdrawal strategy. However, there are so many nuances and factors to consider that it’s vital to sit down with a tax and investment professional to figure out the most efficient and effective path for your savings.
Catch-Up Contributions Can Make a Significant Difference
Once you reach 50, you can increase your contributions by another $1,000 a year. That extra contribution could easily double in size by the time you quit working, drastically improving your retirement readiness. For example, if you put in an extra $1,000 a year for fifteen years with a market return of 7%, your $15,000 extra dollars would inflate to about $25,000. Add another ten years of compound, and your contributions would grow to $49,433.
When NOT to Maximize Your IRA
Depending on your circumstances, it may not be optimal for you to maximize your funds because they could serve you better elsewhere.
You Have a Workplace Retirement Plan
The mere existence of a workplace retirement plan such as a 401(k) can significantly influence your IRA contributions. If you’re leaning towards Traditional IRA contributions in 2023, it’s crucial to understand how your income affects your deduction eligibility. For single filers, if your income is $73,000 or less, you’re entitled to a full deduction up to your contribution limit.
However, if your income exceeds $73,000 but is less than $83,000, your deduction begins to taper off. During this ‘middle income’ phase, your ability to deduct contributions is reduced and gradually phases out. Once you surpass an income of $83,000, you are no longer eligible for a deduction on your Traditional IRA contributions.
For married couples filing jointly in 2023, the income thresholds adjust accordingly. A full deduction is available if your combined income is $116,000 or less. Should your income be greater than $116,000 but less than $136,000, you enter the phase-out range where your deduction for Traditional IRA contributions is reduced. Once your income reaches $136,000, you lose the opportunity to deduct your contributions.
As for the Roth: For single filers interested in post-tax contributions, you’re eligible to contribute the full amount if your modified AGI is under $138,000. As your income increases, the amount you can contribute reduces, phasing out entirely once your income reaches $153,000.
The income limits for those married and filing jointly are higher; you can contribute the maximum to your Roth IRA with a modified AGI of up to $218,000. Above this, the contribution starts to phase out, ceasing entirely for incomes exceeding $228,000.
If any of these income limitations apply to you, you should sit down with a financial advisor and review your options. Even if your income exceeds the limit for qualified deductions, you can still contribute to a Traditional IRA without the deduction and even convert those contributions to Roth. Still, it’s a process that can have significant tax ramifications. Alternatively, you could begin investing in other tax-efficient ways, such as ETFs in a brokerage account.
You Have Other Priorities
It really doesn’t make any sense to contribute to an IRA if you have a mountain of bad debt or don’t have an emergency fund. Only begin contributing to an IRA when your savings will grow faster than your debt, and an emergency won’t wipe out your retirement savings. Moreover, if you’re planning major life events like buying a house or funding education, these should be considered.
Maximizing your IRA contributions can be a savvy move, but not always. Yes, it offers tax advantages that can help you secure a comfortable retirement. Still, your financial situation, like existing debt and emergency funds, may dissuade you from maxing out – at least for now. Additionally, workplace retirement plans and income levels can heavily influence the tax benefits of IRA contributions.
Need tailored advice on optimizing your retirement savings? At Walters Strategic Advisors, we combine CPA expertise with financial planning to craft a personalized path for your retirement. Reach out to us for guidance on creating the most effective retirement plan tailored to your unique financial landscape by clicking the button below!