IRA Pitfalls

Choose your IRA investments wisely.

For many workers, their IRA accounts are second only to their 401k funds in terms of size and influence on retirement security. IRA accounts provide a level of flexibility not found in many other retirement programs, but that flexibility can cause some problems as well. Being aware of the potential pitfalls of IRA accounts is the best way to avoid those problems.

Not Saving Enough

Your IRA is just one part of your retirement planning picture, but it is a very important one. Not saving enough is perhaps the biggest risk of all, because you will have to rely in large part on the money you accumulate while you are working. Max out your IRA if you can each year, as this can allow you to build the significant nest egg you will need when you stop working. For 2011, you can put in a full $5,000, plus an extra $1,000, if you are 50 years or older.

Poor Investment Choices

The IRA account itself is merely a shell, and it is up to you to fill that shell with appropriate investments. If you choose the wrong mix of investments for your IRA, the account could fail to grow as large as you need it to. In fact, the account could even lose money if the investments you choose fall in value. It is important to design a mix of stocks, bonds and fixed income investments that reflects your investment style, your tolerance for risk and your time horizon. Many investors prefer to use widely diversified mutual funds, such as index funds, to reduce the risk in their IRA accounts.

Choosing the Wrong Type of IRA

Workers can choose a traditional IRA, which provides an immediate tax break which rises along with the amount of the contribution, or a Roth IRA that has no up-front tax break. But while the withdrawals of traditional IRAs are taxed as ordinary income, the withdrawals on Roth IRAs come out tax-free. Roth IRAs tend to work best for younger workers, because the longer time horizon can provide a larger nest egg and a larger stream of tax-free retirement income. Choosing the wrong IRA could reduce the size of your benefit, especially if tax rates rise in the future.

Unwise Roth Conversions

Converting a traditional IRA to a Roth can be a smart move, but it is not the best choice in every case. When you convert the money in your traditional IRA to a Roth, you trigger a tax on the funds you convert, and that tax bill can be significant for high balance accounts. Roth IRA conversions tend to be a better deal for younger workers with smaller accounts, because the tax hit is much less and the workers have decades of growth to look forward to. The calculation becomes much more difficult for older workers, because they may not have enough time for the growth of the plan to make up for that initial tax hit.

References

• The Motley Fool: All About IRAs - Traditional vs. Roth
• CNN Money: Retirement Planning - Am I Saving Enough?