Individual retirement accounts are a smart, tax-advantaged way to stash away an age-appropriate amount of money every year for retirement — particularly if you don't have a workplace savings plan like a 401(k). If you have an IRA, it could be a sign you are more financially fit than most.
The only problem? Many people aren't actually using their IRAs correctly — or in a way that will actually prepare them well for retirement, according to a new analysis from the Center for Retirement Research at Boston College.
While Americans have collectively put $7.8 trillion into tax-advantaged IRAs, only 13% of new money flowing into them comes from people contributing directly and regularly. Instead, the vast majority of money in IRAs is money that has been rolled over from an old 401(k).
What's wrong with rolling a 401(k) into an IRA, anyway?
IRAs are a great way for people without employee-sponsored 401(k) plans — like freelancers, entrepreneurs or employees at small businesses — to contribute into a tax-advantaged account for retirement. Whereas your 401(k) contribution is automatically deducted from your paycheck before taxes, you have to make IRA contributions with the cash you have on hand — though then you can take a deduction when you pay your taxes, which will save you money.
There's nothing wrong per se with rolling over an old employer-sponsored retirement account into an IRA after you leave the company — you've got to do something with all that money, and cashing out the money to put in your bank account comes with harsh penalties. Plus, moving the money from a 401(k) into an IRA can also give you more investment options than you'll get from your job and might help you save on fees. Sounds great, right?
There's just one problem: The makeup of IRAs suggests that after people roll their 401(k) money over to an IRA, they don't actually continue to contribute on their own. If they did, you'd see a more equitable breakdown between direct contributions and rollovers. In fact, only 14% of people actively contribute to an IRA versus a third of people who actively contribute to their 401(k).
Without regularly contributing to your IRA, you'll miss out on the compounding effect that will get you to the roughly $1 million that you probably need for retirement. Even just contributing a small amount — like $100 a month — can add up to six figures by the time you retire. But your nest egg won't grow nearly as much if you just let it sit there. And that's not all.
Do you have the right kind of IRA?
Another problem the study results reveals is that many people who do have IRAs aren't actually the ones who need them most. Researchers found that IRA contributors are more likely to already have a 401(k), earn an average annual household income of $110,000 — and be college-educated, married and white.
"IRAs are barely serving lower-income families who may have some money to save and could benefit from the tax advantages of the accounts," the Wall Street Journal reported.
Conversely, those holding both traditional IRAs and 401(k)s might actually be best off using their $5,500 total annual IRA contribution limit to instead max out a Roth IRA, which could give you a better-diversified mix of pre- and post-tax dollars to spend in your golden years — especially if you end up in a high tax bracket. Roth accounts are useful because you get no tax perks upfront, but get to grow and withdraw your money tax-free.
Opening a Roth IRA helps you hedge against a potentially large loss from high taxes when you withdraw from your 401(k).
How do you even open an IRA?
One reason why people with lower incomes may not be getting an IRA on their own is because signing up can be difficult. Right now, you have to open a brokerage account like Fidelity or TD Ameritrade to get one.
These types of brokerage accounts often come with high minimums and hidden fees. Instead of making workers do all this leg-work on their own, researchers argue that more states and cities should set up plans than enroll workers in a plan automatically, as California has done with its Secure Choice retirement plan. Workers who get automatically enrolled in a plan are 13 times more likely to contribute.
"It is time to turn IRAs back into an active savings vehicle by auto-enrolling those without an employer plan into these accounts, with the ability to opt out," the authors wrote in the study.
If you don't get a retirement account through work and don't have a ton of savings, one thing to consider is getting a MyRA, which is offered by the Department of Treasury, has no minimums, and a fixed return, meaning there's no risk. Once you accumulate $15,000 in your MyRA, they kick you out, but at that point you'll be able to qualify for most types of brokerage accounts.
Here's Mic's full guide to opening an IRA.
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