Roth IRAs are one of my favorite investment vehicles because they offer great tax benefits, especially now that the IRS removed the income limitations for Roth IRA conversions, making Roth IRAs more easily accessible to virtually everyone. That said, there are some limits to how much of a good thing you can have and the IRS imposes strict contribution limits on all IRAs. In addition to the contribution limits, IRAs are a use it or lose it proposition – you only have one opportunity to make the contribution, and once it is gone, it is gone. This article will show you how you can take advantage of the tax benefits IRAs offer and maximize your contributions.
How to Max Out Your Roth IRA Contributions
We are going to work with the assumption that you already have an IRA. If you don’t, then here is an article that discusses where to open an IRA. In addition, I frequently reference Roth IRAs because I believe them to be the superior option for most people, however, these tips work or both Traditional and Roth IRAs.
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Once your IRA is open you need to fund it. You can do this one of several ways: contribute a lump sum for the entire year, set up a monthly allotment to maximize your contributions on a monthly basis, or a combination of these. Let’s a look at a couple examples and the pros and cons of each.
Maximizing IRA Contributions with a Lump Sum
People under age 50 can contribute up to $5,000 per year in an IRA, or up to $10,000 per couple (people age 50 and over can contribute $1,000 more). If you have the money available to invest all at once without affecting your cash flow or emergency fund, then this is a good way to max out your contributions and be done with it.
- Pros: Studies show the lump sum investing at the beginning of the year almost always out performs market timing or investing via dollar cost averaging, or making regular contributions throughout the year.
- Cons: There are some downsides to investing all at once – the first is you could invest everything right before a market crash or adjustment and lost a lot of money (dollar cost averaging would spread your contributions and minimize your upside and downside). The other risk is contributing too much if you are near the Roth IRA or Traditional IRA income limits. Did you contribute too much? Here is what to do about excess Roth IRA contributions.
Maximizing IRA Investments with Dollar Cost Averaging
Dollar Cost Averaging (DCA) is a method of investing where you make contributions on a periodic basis (usually monthly, or with your paycheck) to the same investment. This is a common way to invest in employer sponsored retirement plans such as a 401k, but also works for individual investments. There are pros and cons to this approach.
- Pros: Dollar Cost Averaging is easy, more affordable for the average investor, and it removes guesswork and market timing from the equation. Setting up automatic monthly payments ensures you always make the investment, and the monthly investments make it easier to maximize your contributions (it is easier for most people to contribute a few hundred dollars each month vs. making an annual lump sum contribution of several thousand dollars). DCA removes market timing from the equation: since you buy the same investment each period, you buy more shares when the value is low and fewer shares when the value is high.
- Cons: There are a couple things to look out for with dollar cost averaging – because you are making more transactions, you may be subjecting yourself to more fees. This isn’t likely the case when making 401k contributions because there normally aren’t transaction fees, but it may be the case if you are investing through a brokerage or buying individual shares of stocks on a regular basis.
How to maximize your IRA contributions with Dollar Cost Averaging. To set your investment contributions on auto-pilot, simply divide your maximum contribution by the number of months (or paychecks). For example, if you want to max out your IRA with 12 monthly contributions, then you would set up automatic investments for $416.66 per month for a single investor ($5,000 max annual contribution) or $833.33 per month for a married couple ($10,000 max contribution). If you are age 50 or over, then divide $6,000 by 12 for $500 per month.
Combination of lump sum and Dollar Cost Averaging
The third way to max out your IRA contributions is to do a combination of the two methods listed above (Value Averaging is another common method). There are a couple ways this can benefit you. For example, say you want to maximize you 2011 IRA contributions, but you haven’t started yet. You can set up a monthly contribution of $416.66 per month for the remainder of the year, then contribute a lump sum of $1,666.67 to make up for the first 4 months of the year. This will ensure you are able to maximize your 2011 contributions and have automatic contributions set up for maximizing your 2012 contributions.
Another way to do it is to set up monthly contributions for the amount you can afford on a monthly basis, then try to make contributions for that tax year before the tax filing deadline. The IRS allows IRA contributions until that tax year’s filing deadline, giving you a few extra months to max out your IRA contributions. For example, if you set up a monthly investment plan of $300 per month at the beginning of the year you would contribute $3,600 by Dec. 31st. You could still contribute the additional $1,400 to max out your IRA by the tax deadline of April 15th.
The benefit of going this route is that it allows you to contribute what you can afford, and still have time to make up for the full contributions if you are able to do so at a later date. It also gives you the ability to reassess your income situation if you are concerned about your ability to make contributions to a Roth IRA based on income limitations.