Roth IRAs are one of my favorite investment vehicles because they offer great tax benefits, especially now that the IRS has removed the income limitations for Roth IRA conversions, making Roth IRAs more easily accessible to virtually everyone. That said, there are limits to how much of a good thing you can have, and the IRS imposes strict limits on Roth IRA contributions.
In addition to the contribution limits, IRAs are a use it or lose it proposition – you only have one opportunity to contribute, and once it is gone, it is gone.
This article will show how you can take advantage of IRAs’ tax benefits and maximize your contributions.
How to Max Out Your Roth IRA Contributions
We will work with the assumption that you already have an IRA. If you don’t, here is an article discussing 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 for both Traditional and Roth IRAs.
Once your IRA is open, you need to fund it. You can do this in several ways: contribute a lump sum for the entire year, set up a monthly allotment to maximize your contributions monthly, or combine these. Let’s look at a couple of examples and the pros and cons of each.
Maximizing IRA Contributions with a Lump Sum
People under age 50 can contribute up to $6,000 per year in an IRA or up to $12,000 per couple (people age 50 and over can contribute $1,000 more as a catch-up contribution).
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.
Advantages of Lump Sum Investing
- Pros: Studies show that lump sum investing at the beginning of the year almost always outperforms market timing or investing via dollar cost averaging or making regular contributions throughout the year.
- The markets tend to go up over the long run, so the longer you have your money in the market, the longer it has to grow in value.
Disadvantages of Lump Sum Investing
- 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 lose 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 income limits or Traditional IRA deductibility 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 periodically (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.
Advantages of Dollar Cost Averaging
- Pros: Dollar Cost Averaging is easy and more affordable for the average investor, removing 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 make the same contribution each period, you buy more shares when the value is low and fewer when the value is high.
Disadvantages of Dollar Cost Averaging
- Cons: There are a couple of 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. Still, it may be the case if you are investing through a brokerage or buying individual shares of stocks regularly.
- Most studies show that lump sum investing is advantageous, with time in the market being more important than timing the market.
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 $500.00 per month for a single investor ($6,000 max annual contribution) or $1,000.00 per month for a married couple ($12,000 max contribution). Learn more about spousal IRAs, which allow you to contribute to an IRA for a spouse, even if he or she has no earned income of their own (this is only allowed for married couples filing jointly).
If you are 50 or over, divide $7,000 by 12 for $583.33 per month.
Combination of Lump Sum and Dollar Cost Averaging
The third way to max out your IRA contributions is to combine the two methods listed above (Value Averaging is another common method). There are a couple of ways this can benefit you.
For example, say you want to maximize your IRA contributions, but it’s May, and you haven’t started yet. You can contribute a lump sum of $2,000 to make up for the first 4 months of the year, then set up a monthly contribution of $500.00 for the remainder of the year.
This will ensure you can maximize your annual Roth IRA contributions this year. You will also have automatic contributions for maximizing your Roth IRA contributions next year.
Another way to do it is to set up monthly contributions for the amount you can afford, 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 $2,400 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 can do so later. 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.
Maximizing Your IRA Contributions Will Help You Reach your Goals
Maxing out your IRA contributions each year is a great way to set yourself up for retirement. The more you contribute each year and the longer your time frame, the more money you will likely accumulate in your IRA.
Keep in mind that each retirement account has different rules regarding how and when you can make withdrawals. For example, Roth IRA Withdrawal rules allow you to withdraw contributions at any time, but there are specific rules regarding when you can withdraw earnings. There are also age limitations. We encourage you to understand the impact of making your contributions as well as what happens when you finally tap into your hard-earned investments!