Congratulations! You have an Individual Retirement Account (IRA) and are funding it. But are you doing enough? Here, we will talk about why you should raise your IRA contribution rate. Even a small increase in the amount you contribute on a monthly or yearly basis can have an impact come retirement. Read on to learn how much your IRA savings can grow based on how much you contribute.
IRA Contribution Rules
For those who are unaware, the IRS sets limits each year on how much you may contribute to an IRA. For 2021, the maximum you may contribute to your IRA is $6,000. If you are age 50 or older, you may contribute another $1,000, known as the catch-up contribution. This brings your total to $7,000. While it’s ideal to contribute the max each year, we know that many people can’t afford to. However, it’s important you contribute as much as you can. This goes for workplace plans as well as IRAs. The old saying “Pay yourself first” rings true. No one is going to force you to save for retirement. Although the government incentivizes saving for retirement, it’s up to you to take the reins.
It’s also important to note the tax benefits of the IRA. All contributions made to an IRA (or other retirement plan) are tax-advantaged. Generally, when you put money into a traditional IRA, you receive an upfront tax break. This is because those contributions are tax-deductible. Any taxes due on traditional contributions are deferred until you start withdrawing from the plan. However, if you (or your spouse) have a workplace plan, your income will determine if you get the tax break. For example, single filers who earned more than $76,000 in 2021, do not receive the tax break. Check out this article about tax deductible IRA rules.
The advantages are different with a Roth IRA. Since Roths are funded with after-tax money, there is no immediate tax break. Instead, all qualified distributions are tax-free. Once you reach age 59 1/2 and the Roth IRA has been opened for at least five year, you will never pay tax on your withdrawals.
Why Raise Your IRA Contribution Rate?
Thanks to the power of compounding, the more money in your plan, the faster it grows. To illustrate, let’s do some simple math. You have $1,000 in your IRA and earn 10% during the first year, for a total of $1,100. During Year 2, you earn another 10%. Using your total at the beginning of the year of $1,100, that 10% nets you $110. This is 10% more than the first year. As that balance grows (either through earnings or contributions), the amount you earn continues to rise.
Now, we’re going to show you some real life examples. This should show you how even a slight raise to your IRA contribution rate will pay off in the long run.
Subject A contributes $1,000 annually to his IRA starting at age 25. This is roughly $83 every month. He continues this every year until age 70. That’s $45,000 in lifetime contributions. Let’s assume a seven percent rate of return. By age 65, Subject A will have an IRA worth $417,426. Not too bad, right? Let’s see…
If everything else is the same, but Subject B contributes $2,000 annually (or $167/month), she will have $834,852. This total includes $90,000 in total contributions.
Let’s do one more example a little differently. This will show you why starting early has a huge impact. Subject C waits until he is 45 years old to start contributing to an IRA. He contributes $5,000 every year until age 70 for a total contribution of $125,000. Assuming the same seven percent earnings, his balance at 70 years old is $394,772.
Not only is it important to raise your IRA contribution rate, but it’s imperative to start as soon as you can.
There are some other reasons to raise your IRA contribution rate. The first one is inflation. According to Investopedia, inflation can be defined as “the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.” This means $1 today is worth less than $1 next year. For example, in 2019, you would need to pay $3.19 for something that cost $1.00 in 1980.
At first glance, that might not seem like a lot. However, if you add a few zeroes, it really adds up. If you bought a car in 1980 for $10,000, you would have to spend $31,900 to buy that same car today. Therefore, as it relates to retirement savings, you need to save more today simply because the value of the dollar diminishes over time. This is especially true for retirement since savings happen over decades.
Next, let’s talk about fees. IRA custodians charge fees for their services. These may include maintenance fees, administration fees and transaction fees. The more you are paying fees, the less earning power your IRA has. Just think how much $50 or $100 annually adds up over the life of your IRA. It’s best to shop around for the provider who has the most competitive fees. That doesn’t always equate to the one that has the lowest fees. For example, if you want to invest in alternative assets, such as real estate, you need a provider who allows this. Here at IRA Financial, we think we offer all the benefits you need at a fair price.
Lastly, there are taxes to consider. At one point or another, the IRS will get their cut. As we mentioned earlier, traditional plans aren’t taxed until funds are withdrawn and Roth plans are taxed before contributing. Essentially, you need to decide when you want your tax break. Higher earning individuals may prefer the upfront break, while those making less may opt for tax-free withdrawals.
Keep in mind that you need more money to fund a Roth. Take your paycheck for example. You have gross pay (pretax) and net pay (after-tax). Thanks to taxes, your net pay is considerably less. If you want to contribute your total gross pay to your IRA, you’ll need to make up the taxes to contribute the same amount to a Roth IRA.
Hopefully, after reading this, you can see why you need to raise your contribution rate. Taxes, fees and inflation will eat into your savings. Do all you can, even if it means adjusting your lifestyle, to contribute as much as you can to your IRA.
If you have any questions about the information in this article, feel free to reach out to us @ 800.472.1043!