10 Missteps With Tax-Sheltered Accounts

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By Jason Stipp and Christine Benz | 02-24-2014 11:00 AM

10 Missteps With Tax-Sheltered AccountsIRAs, 401(k)s, and Roth accounts are key components of your toolkit,

so make sure you get the most out of them.

Jason Stipp:I'm Jason Stipp for

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doing partial conversions, which are completely allowable. The beauty of a partial

conversion is that you can convert just enough so that you don't push yourself into

a higher income-tax bracket for the year in which you do the conversion.

Work with an accountant on this. If you have a lot of IRA assets that you want toconvert, it can be a great strategy to do it piecemeal over a period of many years.

Also bear in mind that you do have an escape hatch. You can do a

re-characterization--essentially a do-over--if you do a conversion and the timing in

hindsight turns out not to have been right.

Stipp:The next mistake that some investors might make, or maybe a lot of

investors, is waiting until the last minute to fund an IRA account for the prior taxyear. Why might you not want to wait until early April 2014 to do your 2013

contribution to an IRA account?

Benz:Incidentally, that's what Vanguard has found. When it looked at when

people have contributed, it found that a lot of people rush the doors right before

that tax-filing deadline.

Foregone compounding is really the main reason that you don't want to do that.

Think back to the beginning of 2013; if you had only made that contribution at the

outset of 2013 instead of waiting until now to make it, you would have had a

year's worth of great appreciation. This is particularly important for younger folks

with longer time horizons. That benefit of compounding when multiplied over many

years can really add up.

Stipp: Turning to 401(k) plans: Of course a big mistake is not at least contributing

enough to get your employer match, but whenyou contribute can also affect the

kind of match that you get, and people can miss out on a match in certain

situations.

Benz:That's right. This is kind of a high-class problem. It's something that higher-

income people sometimes run into, where they max out their 401(k) plans veryearly in the year. What happens is that they haven't taken full advantage of

employer matching contributions, which are usually spaced out on a per-pay-period


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basis. So you want to be careful: If you've earned a bonus and you're contributing

at a very high level, you could actually not benefit from your full employer

matching contributions.

Some plans have instituted a provision that actually will give employees fullmatching if they have maxed out their contributions, even if they've done so in the

first part of the year. But check with your plan. If your plan does not have such a

provision, you want to be careful to space out your contributions pretty evenly.

Stipp:Mistake number six involves not considering how a possible Roth 401(k)

option could be beneficial for you when you do reach retirement.

Benz:For a lot of people, splitting the difference between traditional 401(k)

contributions and Roth 401(k) contributions can be the way to go, because really

what you have to decide when you choose which type of contribution to make is

what sort of tax bracket you will be in during retirement versus where you are

now. A lot of people say, I have no idea--especially younger earners. For them,

splitting between the two account types, which is usually an allowable option, is

the way to go.

Stipp:Another mistake involves a different kind of tax-sheltered account, the HSA

or the health savings account. Some investors may say, I'm not going to use the

HAS; it's not for me. But there could be benefits for some folks here.

Benz:Health savings accounts are used in conjunction with high-deductible

health-care plans. A lot of people might say, I don't want to pay the deductibles out

of pocket, or it's just more complicated than investing in the traditional health-care

plan, and that's all true.

But particularly people who are healthy and wealthy--so, who are already maxing

out their other tax-sheltered vehicles and are in pretty good health, and probably

won't have a lot of out-of-pocket health-care costs--for them, HSA can be a really

nice tool in their toolkit.

In particular, it has three tax-saving benefits. You make pretax contributions, you


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enjoy tax-free compounding on the money, and then assuming that the

withdrawals are for qualified health-care expenses, that money is tax-free, too. So

it's one of the only triple-tax-benefited accounts in the whole tax code.

Stipp:Mistake number eight also involves 401(k) plans, and that's automaticallyrolling over the 401(k) to an IRA when you retire or when you switch jobs. There

are a lot of good reasons to do that, but there are also some reasons to keep

money in the 401(k) plan in certain circumstances.

Benz: I often say the rollover is the best answer in part because you can get away

from that extra layer of fees that accompanies a 401(k) plan and isn't there with

an IRA. But if you are in one of a couple of different categories, you want to steerclear of the rollover and instead stay put in the 401(k).

The first is if a lot of your 401(k) assets are in company stock: Check with an

accountant on this, but oftentimes it will be better to leave that money in the

401(k), because you'll be able to enjoy capital gains treatment on the money when

you begin withdrawing it in retirement.

The other category is for people who are between age 55 and 59 1/2 and they

want to begin withdrawing money from the 401(k) during that time period. They

may be able to begin withdrawing from the 401(k) before age 59 1/2; they can't

do that from an IRA without incurring a 10% penalty.

Stipp:A couple of portfolio planning mistakes: The first one is not thinking about

your asset location, or what types of investments you put into these accounts.

Benz:You want to keep in mind that you do enjoy tax-free or tax-deferred

compounding on your money. In general, if you have any sort of investment types

that are kicking off a lot of ordinary income, you want to make sure that you're

housing them within tax-sheltered accounts. You can hold other types of

assets--like index funds, for example, or municipal bond funds--in your taxable

accounts because they will tend to be very tax-friendly on a year-to-year basis.

So keep in mind that concept of asset location when you think about which types of

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investments to place where.

Stipp:But sometimes that asset location can change, especially as you move into

retirement?

Benz: That's right. So, in particular, you'd want to think about getting bonds

relocated into your taxable accounts because those are typically the first accounts

you'd want to deplete in retirement.

Stipp:So, there can be some twisting that happens as you get into retirement.

Benz:Exactly.

Stipp:The last mistake is not using taxable accounts. Even if you have

tax-deferred accounts, there are some reasons that you might want to have

taxable accounts, especially when you get into retirement?

Benz:That's right. One of the key reasons is that for some people--especially,

again, people who are in the higher-income bands--putting the full contribution

into the IRA and 401(k) just may not be enough given your income demands in

retirement. You will need to use taxable vehicles as well.

The other key reason to consider it is that, when you are actually retired and

you're beginning to withdraw those assets, you can really be quite strategic about

where you go for cash--which of your account types you'd tap for cash. And those

taxable vehicles, especially if you are paying a lot of attention to what types of

assets you're putting there, can be pretty tax-friendly on a year-to-year basis.

If you find yourselves in a very high-tax year and need to pull some money out,

you may be able to enjoy pretty low capital-gains treatment on the money that's

coming out of those taxable accounts. So, definitely tax diversification is a goal for

people who are getting close to retirement.

Stipp:Christine, the tax-sheltered account is one of the most important tools in

investors' toolkits. Thanks for helping us use those better today.

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Benz:Thank you, Jason.

Stipp:For Morningstar, I'm Jason Stipp. Thanks for watching.

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sandsok

Feb 27 2014, 7:03 PM

I don't think that we are in a minority, but we don't make much

money for the companies and therefore we are NOT a priority. I

have watched for years and have yet to see any important

discussions on people who are already retired with the same assetsthat "wazone" talks about.

chuck49

Feb 27 2014, 3:38 PM

Has anyone noticed how hyper this discussion was? It made me

nervous just watching it. Christine is usually a more relaxed

speaker, so perhaps this video was sped up to make info more

palatable to the gamer generation?

williamr

Feb 25 2014, 3:11 PM

Unless you are certain your retirement tax rate will be lower,

consider saving funds in all three basic type of accounts: taxable,

tax-deferred (traditional 401K/IRA), and tax-free (Roth 401K/IRA).

We have all three (80% in traditional IRA today), are over 70.5, but

made the mistake of draining the taxable account first (paid almost

no tax for a few years). We now only live off of the traditional IRA

(SS is not enough to pay the taxes on the withdrawals). It would

have been much smarter to pay more tax earlier by withdrawing

some traditional IRA funds immediately and slowing the withdrawal

rate of funds in the taxable account to keep us in a lower tax

bracket for a longer period of time. We keep the Roth IRA

untouched as a safety net for medical, long-term health care,

emergencies, or estate taxes.

Flipper

Feb 25 2014, 2:40 PM

@content and wazone:

You mean like this one?

http://news.morningstar.com/articlenet/article.aspx?id=636472

wazone

Feb 25 2014, 2:30 PM

I agree with "content"--OK on the 70.5 as described--but what if you

are 80.5 like me, when will we hear that discussion ?

Bruce47

Feb 25 2014, 12:56 PM

For me, the first question to ask regarding a 401(k) to IRA

conversion is whether the company will allow beneficiaries to

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continue new ownership in their respective pieces of a 401(k)

account when the retiree dies. If not, a very large and unavoidable

tax bill may come due! If so, the heirs can continue the tax deferred

status and make their own withdrawal and conversion decisions.

content

Feb 25 2014, 12:43 PM

When will you discuss tax savings issues for couples over 70.5, with

no earned income, just pension, SS, Dividends and CG? These folks

cannot put new money in IRAs, Roths, 401Ks, HSAs, etc. Or are we

in such a minority that it is not a priority on your list?

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10 Missteps With Tax-Sheltered Accounts