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Do you know this key to maximize IRA contributions?

April 5, 2011 at 5:03 p.m.
Updated April 4, 2011 at 11:05 p.m.

Dave Sather

April 15 is right around the corner. This means two things.

First, income taxes are due and, secondly, the deadline to make IRA contributions for last year is upon us.

Contribution limits are the same - $5,000 per person, plus an additional $1,000 "catch-up" contribution if you are 50 or older.

If you make less than certain levels, or do not have a qualifying retirement plan available to you, then your Traditional IRA contribution may be income tax deductible.

Furthermore, the entire time your funds stay invested in the IRA, they grow in a tax deferred manner. The tradeoff is that when you pull funds out, you pay taxes on everything that has not been previously taxed.

The Roth IRA has the same contribution limits and has restrictions on how much money you can earn and still contribute directly into a Roth. The Roth does not provide an income tax deduction up front, but the earnings are completely tax exempt. As such, if income tax rates go up in the future, as many expect, the Roth may be a good strategy to hedge future tax increases.

What if you can't make an income tax deductible contribution to a traditional IRA and you make too much to contribute directly to a Roth IRA?

The government changed the law last year on converting a traditional IRA to a Roth IRA. As such, anyone, no matter their income level, can use this strategy.

A high income earner can contribute $5,000 to a traditional IRA. They can then immediately convert that traditional IRA to a Roth IRA. By doing so, high income earners can still sock away funds that offer tax exempt savings.

Because we know that all income earners can benefit from an IRA, it is worth analyzing when to contribute.

Most people wait until April to make IRA contributions for the previous year. However, if you really want to supercharge retirement savings, consider doing so early. There is no law stating that you must wait until the next April to make contributions. In fact, you can make contributions to an IRA as early as Jan. 1 of a new year.

What does this early contribution get you? In simple math, it means that your contribution gets invested up to 15 months earlier. Furthermore, these early contributions continue to grow over the next several decades.

How much of a difference can this really make? Assume that at the end of each year you save $5,000 for the next 30 years and those funds grow at 10 percent per year. At the end of that time, you will have saved about $822,000. Not too bad.

However, how much would you have accumulated if you had done exactly the same, but funded your IRA on the first day of the year instead? Amazingly, this small change means that you will accumulate more than $904,000 after 30 years. Simply by starting at the beginning of the year you end up with 10 percent more when you need the funds for retirement.

The earlier you start, the larger the difference becomes.

Assume the same contributions and the same earnings rate, but over a 40-year timeframe. The investor who waits until the end of the year accumulates a sizeable $2.21 million. However, the proactive investor who invests on the first day of the year accumulates more than $2.43 million!

Knowing this, anyone can invest in a Roth IRA. However, the sooner you start and the more consistent you are, the more you can save in an income tax exempt manner for retirement.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.

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