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Boosting Your IRA Contributions

We all want to do our best to plan for the future. Whether it is saving for a child’s college, or putting away some cash for our retirement, we want to do our best.

For most of us, the best way to plan for retirement is with an IRA. There are several different types of IRAs, but the two you will most often hear about are the traditional IRA and the Roth IRA.

First, let’s look at the differences in the two types of IRAs.

Traditional IRA: In the traditional IRA, income you invest into the IRA is tax deductible, and you earnings grow tax-free until you take the money out down the road, at which point the money will be taxed at your ordinary tax rate.

Roth IRA: Unlike a traditional IRA, contributions made into a Roth IRA are not tax deductible. The difference is that when you withdraw the money in the future, assuming it has been open over 5 years and you are older than 59 ½, the money, and earnings are tax-free.

One thing to remember is that in both cases, you are looking at a 10% penalty if you pull out the money early.

For both traditional and Roth IRAs, the 2012 limit on the amount you are able to contribute is $5,000, but that number will increase to $5,500 in 2013. For most of us, that is big enough, but for some there is the desire to invest more than $5,500 a year into our IRAs. While this is not possible, there are a couple of ways to increase your contribution.

Dividends

Dividends are a good way to add extra cash to your IRA each year. The income you earn from dividends is not counted against your contribution limit, so they act as a nice addition to the money you are already setting aside. Some people prefer to set their IRAs to automatically reinvest their dividends, while others prefer to simply receive the cash. Either way you are getting the same amount of extra income into your portfolio, but if you opt to go with cash then you will have a little extra each dividend cycle to invest in other stocks that you would not have been able to otherwise.

Selling Options

A second easy way to add some extra cash to your IRA is to sell out of the money calls against your positions. This procedure is known as a covered call, and you first need to make sure that your IRA is set up to allow you to trade options. In most cases, IRAs are not originally set up to allow for options, so you may need to contact your financial institute to get that set up.

Setting up a covered call is a fairly easy process, the only requirement being that you need to own at least 100 shares of the underlying security. The best stocks to use for covered calls are those that never really go up a lot or down a lot. They are the perfect candidates for this investment strategy. A good example would be General Electric (GE). If you look back at the last four years, you will notice very little volatility in the stock. It is a great candidate.

GE is currently trading at $21.05. Let’s assume that you own 100 shares of the stock. You could sell the February 22 call against your stock for $0.30, pulling in a $30 credit to your portfolio (minus commissions). The hope is that on February expiration the stock will close trading at $21.99. In this scenario you enjoy a $0.95 increase in your stock, and you get to keep the $30 you pulled in from your sold call. Should the stock close above 22, you sell the stock at $22, which is not necessarily a bad thing unless the stock were to skyrocket above that level.

You have to set these up with a strike price where you are willing to sell the stock. Are you OK getting out of your GE at $22 a share? If so, then why not add an extra $30. If you would not want to sell your GE at $22 then you need to find a different stock to sell calls against, or use a different strike. The main thing is that you want to keep the duration of your sold calls between 1 and 3 months.

If done right, you can have a nice addition of cash into your portfolio. The other advantage is that even if the stock does trade above your strike and you are forced to sell your position, you have removed emotion from your trade. You take your profit and move on to the next trade. You do not have to second-guess whether to hold on to your stock and possibly watch profit takers came in and push the stock lower while you are still holding onto your position.

Whether you go with dividend investing, or selling out of the money calls against your stocks, you can see how easy it is to add additional income into your IRA accounts.

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.