Step 11: Max IRA Contributions

Two questions. First, are you contributing to an IRA account for retirement? Second, are you doing the max IRA contributions allowable amount each year? (assuming you are eligible to do either) If you can answer yes to these questions feel free to move onto the next step in the Path to Financial Independence. If not you need to keep reading on why they can be so important for your future.

Max IRA Contributions

Wait… I want to start at the beginning.
Link to the previous step – Step 10: Pay Down Moderate Debt

What is an IRA and do I really need one?  An IRA, or individual retirement account, is a retirement specific account designed for a person with no access to an employer sponsored plan or wants to save (more) on their own each year tax-advantaged.  There are two main types of IRA accounts that vary mainly on whether you would like tax-free growth in the account or tax-deferred savings up front.  

Technically, a lot of financial houses include a third type called a Rollover IRA which is when you transfer money from a qualified employer-sponsored plan to an individual retirement plan.  To me, it is basically the same as the other two but varies in the source of the funding initially. There are accounting and tax reasons to keep them separate in their system but not necessarily in yours.

What are the max IRA contributions?

Both types of accounts currently have $6,000 annual max IRA contributions set by the IRS, but please check their website for any updates on that amount before taking action.  This annual limitation is one reason why you shouldn’t delay starting and funding one of these retirement accounts because there is no way to catch up on those missed years.  

People over a certain age are allowed “catch-up contributions” but it isn’t double and certainly won’t make up for the years of lost compounding gains.  Bottom line is that you should start saving in your IRA last year… don’t wait.

Traditional IRA vs ROTH IRA

The difference between a regular IRA and a ROTH IRA is lengthy and nuanced. Since personal finance is so personal and I don’t know your particular situation, I won’t outright recommend one over the other. There are tons of resources for that debate. Fire the Family does a nice breakdown of the pros and cons between the two types of retirement accounts.

The short version of their difference is that in the traditional IRA, you are able to save the money tax-deferred this year but will have to pay taxes on the withdrawals in the future.  You are able to deduct any money contributed to a traditional IRA from your taxes in the current year.  This is a great way to lower your taxable income each year and save more of that money now to grow and compound for years to come.  

Pay taxes now or pay them later?

Many people believe that they will be in a lower tax bracket when they retire (or FIRE), so reducing your tax burden today at your current rates and deferring it into the future where you’ll be in a lower tax bracket (hopefully) can make sense.  

Conversely, the ROTH IRA allows you to put after-tax savings in the account and have it grow tax-free until retirement.  This is ideal if you are in a particularly low tax bracket now and plan on having more income in retirement.  Many people like the idea of the ROTH because the assumption is that your money will grow in your investment accounts over time and it is better to pay the taxes on the smaller deposit today than the appreciated balance in the future.  

I like the tax savings now, but you do you

While I can’t entirely argue with that logic, it doesn’t take into account the additional money you can save today (the money not paid to taxes) and how that compounds over time.  It is very possible that the extra compounded gains from those tax savings will outpace the additional tax burden you’ll have when withdrawing it.

Granted, these are all assumptions about the future when trying to determine if taxes on your income or withdrawals will be higher or lower today than when you retire.  Maybe you are unfathomably wealthy and withdraw far more in retirement than you earn today.  That’d be a horrible problem, right? haha

The future is hard to predict

There is possibility that governments alter the tax structure in the future to shift that variance.  It is possible that it works out exactly as you thought it could too.  The point is that all of these assumptions should be taken into consideration when deciding which type of account to open.

When in doubt, get expert advice

In fact, if you aren’t sure or your personal financial situation warrants it please consult with an accountant or fiduciary.  The IRS imposes income-based limitations on both the type of account you can open and contribute to each year.  A quick check with the IRS website and/or a personal finance professional should be able to help you sort out which account works best in your situation.

One thing to note here is that you can contribute to an IRA even if you contribute to the 401k at your office, subject to income and type limitations.  This can really help ramp up the amount you are saving each year tax-deferred.  You could always save this money in a regular brokerage account but you’d miss out on the tax advantages either of these accounts allows.

How we max contributions to an IRA

Personally, we have a traditional IRA for one of us (who does contract work and has no 401k option) and a ROTH IRA for the other (who has a company 401k).  It may not be the 100% most optimal choice for my account but I figure I can go ROTH on the $6,000 a year in the IRA to hedge our bets on the traditional 401k money being saved tax-deferred.  That one helps me sleep at night because then I can pretend I’m playing both sides of the coin. Either way, employing max IRA contributions help us take advantage.

The ROTH Conversion Ladder Hack

Speaking of trying to determine if the traditional or ROTH account is best in the long run, the MadFientist wrote an article a few years back that blew my mind. He discusses how you can use a “ROTH Conversion Ladder” to functionally contribute tax-advantaged to a regular IRA, convert it to an IRA with minimal tax penalty, and withdraw it tax-advantaged.  

I’m not sure I can fully take advantage of the ladder because I won’t be retiring as early as he did but it is intriguing.  That said, the article made me realize the endless possibilities to be creative in personal finance.  The concept still amazes me today and I cite it frequently in the traditional vs ROTH debate.  Go read it for yourself and potentially rethink your retirement account strategy.

Note on advanced IRA moves

There are more advanced IRA considerations like the backdoor ROTH and the Mega Backdoor ROTH contributions that I won’t go into detail here.  Just know that it is a way to deposit more than the $6,000 maximum each year potentially and/or a way to contribute at all if your income would normally exclude you from participating.  Feel free to look those up.

Example

The company I work for has a program for automated in-plan ROTH conversions inside your 401k. Basically what that finance word salad means is that during the year if I contribute more than the IRS allows pre-tax they will automatically convert any post-tax contributions to ROTH. Essentially it is a backdoor ROTH contribution with fewer steps.

Let’s say I set my contribution % very high and that means I’ll eventually contribute $40,000 to my 401k pre-tax (I wish haha). In that scenario, sometime around July I’d hit the $19,500 maximum allowed per the IRS and all future contributions will be post-tax. After every paycheck, the system does a sweep and converts any post-tax money to ROTH 401k contributions.

Why would you do this?

The main advantage of this employer automated in-plan conversion is the amount you can contribute tax-advantaged. Normally, the IRS limits you to contributing $19,500 to your 401k and $6,000 to your IRA for a total maximum of $25,500 annually. There are income-based limitations and nuances to that figure, but go with me for now.

In the fantasy scenario above, we were able to contribute $40,000 to tax-advantaged accounts in a single year. “Time in the market beats timing the market”, so the ability to stuff even more money into these special accounts can be a huge bonus.

TL;DR

Find out if you can open and fund an IRA.  Do so if you can. Make sure to check with the IRS regulations on the type of account you are eligible for as well as contributions limits. Everyone’s situation is different and it is best to check before making financial moves.

Link to the next step – Big Purchases