We hear it every year, especially between the end of the year and the tax filing deadline: It’s time to make your IRA contribution.
It’s good advice. For 2023, you can set aside up to $6,500 (if you’re under 50) or up to $7,500 (if you’re over 50) in an IRA account that offers either tax-deferred (Traditional IRA) or tax-free (Roth IRA) growth. Now, those contributions and their deductibility may be capped by your income levels, so if you haven’t made your IRA contribution yet, you may want to talk to an accountant or tax professional.
But, assuming you’ve run the numbers and/or cleared it with your tax pro, now that you’ve made the IRA contribution, what, exactly, are you supposed to do with it?
Historically, the best option is to invest it in a blend of fixed income and equities, and the wide variety of mutual funds and ETFs that are available these days makes it fairly easy to build a diversified portfolio with any dollar amount, including one year’s worth of IRA contributions. But those aren’t your only options. So, let’s explore some of the choices that are available to retirement savers, their pros and cons, and figure out which option gets you on the right path to building a retirement nest egg.
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The list below is ordered from most to least conservative.
5 Ways to Put Your IRA Contribution to Work
#1. If You’re Terrified of Investing
Cash and Money Market Funds. You understand the tax benefits of the contribution and you know you need to save for retirement, but the thought of taking any risk with your hard-earned money petrifies you. That’s okay. You won’t generate much in the way of returns (and may not keep up with inflation) but interest rates are far more favorable now than they have been at any point in the last decade.
If it was a stretch to even make the contribution at all, and you’re worried that you might actually need that money before you retire, keeping it in cash or money market funds is an option. If you do end up pulling the money out of the account early, you’ll be hit with early withdrawal penalties (subject to some exceptions), but cash in bank or brokerage accounts is insured and liquid. Plus, (especially if it’s your first IRA contribution) it’s important to remember that just because your contribution is in cash now doesn’t mean it has to stay in cash forever.
#2. If You Don’t Want to Think About It
Target-Date Funds. You made the IRA contribution and aren’t worried about having to claw that money back for some unexpected emergency, but you don’t really want to think about it other than once a year when you make your annual contribution.
Perfectly fine, that’s how most Americans think about their 401(k)s: money comes out of your paychecks, it goes through some magic accounting, and boom, retirement savings (Editor’s note: that’s not actually how this works). Target-date funds are as close to “set it and forget it” as you can get with retirement savings. You pick a year far out in the future close to when you think you’ll be retiring, and the target date fund periodically rebalances, getting more and more conservative each year as you approach that date.
The funds are typically funds of funds and own a portfolio of other mutual funds or ETFs. If you’re decades away from the target date, say a 2055 fund, you’ll be invested in more stocks, and less bonds and cash, and as the date draws closer, the fund managers will move the dials to put more in bonds and cash and less in stocks.
#3. If You Have Some Opinions
A Diversified Portfolio of Funds. If you made your IRA contribution and want to have more say in how it’s allocated, a portfolio of diversified mutual funds or ETFs is a good option. Rather than relying on the fund company to rebalance for you, you’ll need to monitor your account and periodically rebalance if and when it gets out of whack (say, if the stock market hits all-time highs and you find yourself with too much money in large-cap stocks and not enough in small caps or fixed income).
Having a diversified, self-directed portfolio allows you to make tactical decisions to put more or less money in certain funds when you see opportunities. It also allows you to specialize a little bit. If you think AI is the wave of the future, you can invest in artificial intelligence funds as a part of your portfolio. Think Chinese stocks are currently undervalued? You can direct more of your retirement dollars to those investments.
It takes more work, but investing in a portfolio of funds can help you better match your investments to your personal investing style.
#4. If You Want Individual Stocks
A Core and Explore Portfolio. You’re comfortable directing your own accounts and want more aggressive investments without straying too far from a traditional diversified portfolio. The premise of a “core and explore” portfolio is that the bulk (say 80%) of your investments are in an age-appropriate diversified portfolio with broad exposure to fixed income, and domestic and international equities.
Since you’ve got one foot firmly on the ground, you can use the other 20% of your portfolio to take on additional risk through individual stock investments. This is very similar to the “If You Have Some Opinions” entry above but allows you to overweight individual stocks or potentially gain exposure to asset classes that would normally be excluded from most retirement accounts (like gold or cryptocurrency for example). This style of investing also allows you to make more speculative (riskier) investments in companies that may have disproportionate upside potential (investing in Tesla a decade ago, buying individual shares of NVDA in 2021, etc.).
It’s not for the faint of heart but may be a better fit for your temperament or help you learn more about investing in stocks in general.
#5. If Your IRA Contribution Is Just the Cherry on Top
For the Next Generation. You’ve got a pension or your 401(k) is overflowing with more money than you’ll ever spend and your IRA contribution isn’t part of your retirement picture at all. Good problem to have right? If you find yourself in this scenario through hard work and diligent saving, congratulations. Now it’s time to think about how to use your excess savings.
In this scenario, consider how to maximize the impact of your IRA contributions for subsequent generations. You can afford to take more risk than someone worried about retirement, which means you don’t need to be concerned about whether your allocation is “age-appropriate” and are free to invest in individual stocks to your heart’s content. You should also consider doing some advance tax planning for your beneficiaries’ sake. That might mean converting to a Roth IRA and pre-paying the tax liability by taking the tax hit now so your beneficiaries won’t have to when they start taking distributions. If you’re at this stage, definitely speak to an accountant or financial planner.
These are all broad strokes and the right move for your IRA contribution is going to be individually specific. But, hopefully, this gives you a few ideas on how to put that contribution to work.
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