This piece originally appeared on The Rich Investor.
The Individual Retirement Account, or IRA, is the backbone of most middle-class Americans’ retirement plans.
Creating the tax-deferred savings vehicle back in 1974 was one of the few unequivocally good decisions Congress has made over the past half century.
Don’t give Congress too much credit though.
An infinite number of monkeys slapping their hands on an infinite number of keyboards will eventually pound out the entire unabridged works of William Shakespeare if given enough time.
By shear random luck our fearless leaders are bound to do something right once in a long while.
But that’s not my point today. This is…
Properly using an IRA’s tax benefits can vastly accelerate your savings plans.
For many Americans, the tax benefits, compounded over a working lifetime, might make the difference between retiring in style or having to move in with your adult children in your golden years.
This isn’t academic for me.
I keep the vast majority of my liquid savings in assorted IRAs, Roth IRAs and similar vehicles.
I’ve done the math and I know that, based on my return and tax rate assumptions, the tax benefits increase my annual returns by 20% to 40%.
At any rate, let’s take a look at how Americans as a whole are using their IRAs.
You can use it as a measuring stick to see how you’re doing relative to your peers, and to see if you need to make any changes.
The Employee Benefit Research Institute (EBRI) published a report earlier this year that looked at account balances, withdrawals, contributions and asset allocations for American IRA investors over from 2010 to 2015.
Interestingly, 87.2% of IRA owners did not contribute a single new dime to their accounts over the six year window, whereas only 1.8% contributed every years.
But before we throw the proverbial low-saving American spendthrift under the bus, I should point out that a lot of these IRAs were probably owned by retirees or by workers who weren’t eligible to contribute because they were (hopefully) squirreling away fresh savings in their company 401(k) plans.
(I say “hopefully” because various studies have shown that only about half of all Americans contribute to a 401(k)plan…)
The more interesting number to me is that, among those who did contribute new funds to an IRA, roughly half maxed out their plans. Good for them!
Not surprisingly, account balances jumped over the 2010 to 2015 period, as the stock market shot higher.
The average balance of investors that owned IRAs for the entire period rose by 47.1%.to $146,513.
But here’s where it gets interesting.
Few investors earn the “average” return, and actual results are scattered all over the place.
The bottom 25% had cumulative returns of just 0.1%, essentially earning nothingover a period of time in which the market was on fire. Meanwhile, the top 25% saw their balances explode higher by 87.3%.
This brings me to asset allocation.
If you didn’t make money between 2010 and 2015, it means you weren’t playing the game.
You were likely sitting in cash, having been shell-shocked by the 2008 meltdown.
And indeed, EBRI found that 27% of IRA owners had zero invested in stocks over the six years covered.
About 17% were fully invested in stocks over the period. The “average” account had roughly half its assets allocated to stocks, with the precise number bouncing around between the mid-40s and mid-50s.
Now, it’s easy to scoff at those who sat in cash over those six years, missing an epic run in the market.
But some of these investors were likely in or near retirement and didn’t want to risk a major drawdown.
And I’ve always said that the most important thing is to simply get the cash into the account to take advantage of the tax break. The allocation can follow later. I reiterate that point here.
But all the same, you shouldn’t be sitting in cash earning nothing. If you can’t accept the risk of a large allocation to stocks, you should at least have your cash in bonds, earning something.
Alternatively, you could consider using my Peak Income service, which is designed specifically to produce higher yields than what is generally available in the mainstream bond market while having a low correlation to the stock market.
The average yield on our current open recommendations is around 7%, which doesn’t include capital gains.
The larger takeaway isn’t that Americans are irresponsible spendthrifts who lack the discipline to save (though certainly there are millions of Americans that would fit that description).
It’s more an issue of Americans trying to be responsible but not quite getting the execution right.
The good news is that this is a much easier problem to fix. Once you’ve done the hard work of saving, allocating your funds well is the easy part.