Keep This Key Number in Mind When Funding Your IRA

Setting money aside for retirement could help ensure you’re able to live comfortably once your career comes to an end and you stop collecting a paycheck. And it pays to look at an individual retirement account (IRA) for your retirement savings.

Traditional IRAs allow you to make contributions on a tax-free basis. This year, IRAs max out at $6,500 for workers under age 50 and $7,500 for those 50 and older. So if you’re 40 and you max out your IRA, the IRS won’t tax you on $6,500 of income. And if you fall into the 24% tax bracket, that means you’ll be reducing your IRS burden by $1,560. That’s a pretty good deal.

Plus, investment gains in an IRA are tax-deferred, so you’re not taxed on them until you take withdrawals. With a taxable brokerage account, you pay taxes on gains the year you take those gains.

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But while a traditional IRA is generally a good account to take advantage of, there’s one hiccup you might face. Because you get a tax break on your contributions, the IRS wants you to leave your money in that account until age 59½ at a minimum.

If you take a withdrawal at an earlier age, you’ll face a 10% penalty for removing your money too soon (though there are limited exceptions to this rule). And so if you think there’s a good chance you’ll end up retiring before age 59½, you may want to keep some of your long-term savings in a taxable brokerage account.

It pays to give yourself options

Although a taxable brokerage account won’t give you the same benefits as an IRA, there’s a big upside: You can remove your money whenever you want. Want to sell some stocks to take a vacation? Go for it. Want help buying a new car? You won’t face any penalties for tapping your investments.

Similarly, if you decide you want to retire in your early 50s, you can withdraw from your brokerage account without having to stress about penalties. That money is yours. The only thing you’ll have to worry about are taxes on capital gains. But when you take withdrawals from an IRA, you pay those, too.

(To be clear, if you’re treating your brokerage account as a long-term savings account for retirement, it’s best not to take withdrawals for vacations or car-buying purposes. These examples merely illustrate that you can do so without penalty.)

Use both accounts to your advantage

There should eventually be a point when you’ll be able to take IRA withdrawals penalty-free. So it pays to keep some of your retirement savings in one of these accounts. But if you know that early retirement is on your radar, then it makes sense to consider splitting your contributions between an IRA and a regular brokerage account.

Let’s say you want to retire at age 55 and have $300,000 in a brokerage account and $300,000 in an IRA at that point. What you can do is raid your brokerage account for the first several years, and then start tapping your IRA once you’re eligible to do so without penalty. But that way, you at least get penalty-free access to some of your investments at an earlier age.

IRAs are a really great savings tool for retirement. But keeping all of your savings in one is a move you might regret. And if you’re tempted to do so for the tax breaks, remind yourself that contributing to an IRA means committing to keeping your money there until 59½ — or otherwise facing penalties on the savings you worked hard to build.

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