If you’re considering a financial New Year’s resolution, prioritizing contributions to your retirement accounts is a solid starting point. This is particularly true if you have the means to max out an IRA.
But when is the best time to reach the maximum contribution limit on your IRA? In the world of investing, there’s often an argument for acting sooner rather than later. However, when it comes to IRA contributions, the decision is not always straightforward. Here’s what you should consider.
The case for slow and steady
Let’s start with a somewhat counterintuitive stance: Why rushing to max out your IRA might not be the best approach. There are several arguments related to cost basis and taxes that support taking a more measured approach.
Dollar-cost averaging to avoid buying at a high
One argument against frontloading your IRA contributions is the possibility of investing at a high cost basis for the year. This means you could end up buying into your investments at a peak price point, potentially reducing your returns (or even leading to losses if the market declines later on).
This concern becomes more relevant when stock indexes like the S&P 500 are at or near all-time highs, as was the case in the early part of this year.
Making smaller contributions over time allows you to leverage dollar-cost averaging, ensuring that your cost basis for IRA investments aligns more closely with the average price over the year. This can help mitigate the risk of buying at a peak.
You can make contributions for the previous year until tax day
It’s important to note that there’s no rush to claim the tax deduction for traditional IRA contributions. To maximize the deduction for a given year, you don’t need to make all contributions by December 31; you have until the following tax day (usually in April) to make contributions.
By making smaller contributions throughout the year instead of frontloading the maximum, you create flexibility to reduce your tax bill at the last minute if unexpected circumstances arise that impact your tax liability.
For instance, if your income increases during the year due to changes like no longer qualifying for certain tax credits, making a last-minute contribution to your IRA can help offset any additional tax burden and boost your retirement savings.
This last-minute contribution strategy can also be beneficial if your income rises to a level where you become ineligible for other tax deductions you were counting on, such as the student loan interest deduction.
On the other hand, if you frontload your maximum IRA contribution and then face unexpected tax liabilities later on, you may have missed the opportunity to utilize your IRA deduction, resulting in a higher tax bill.
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The case for making contributions as soon as possible
However, there are also reasons to consider maxing out your IRA early, especially if you’re contemplating strategies like a backdoor Roth IRA.
More time to grow
While there are various considerations regarding tax implications and cost basis, one fundamental investing principle to bear in mind is that earlier investments have more time to grow, potentially leading to higher returns.
Historically, the S&P 500 index has seen an average annual return of around 10% before inflation over the last century. Although returns can vary, stock indexes generally show consistent long-term growth.
If the market performs well in a given year, investors who contribute to their IRA early are likely to benefit from higher returns compared to those who spread out their contributions.
While dollar-cost averaging helps mitigate the risk of investing at a high point, acting as soon as possible has the potential to maximize returns in a strong market.
Funding other retirement accounts
For individuals with high incomes who are ineligible for direct Roth IRA contributions, a backdoor Roth IRA could be a viable option. However, it’s essential to be mindful of the tax implications associated with this strategy.
In such cases, it may be wise to first maximize traditional IRA contributions before pursuing a backdoor Roth IRA. This makes early contributions to a traditional IRA a favorable approach.
If you’re unsure about the best way to manage your IRA contributions based on your specific circumstances, seeking advice from a financial advisor could be beneficial.