6 IRA Mistakes to Avoid

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Christine Benz is Morningstar's director o f

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6 IRA Mistakes to Avoid

Contributing to an IRA might seem goof-proof, but these mistakes trip

up even seasoned investors.

By Christine Benz | 03 -16-14 | 06:00 AM | Email Article

The clock is ticking for IRA contributions that will count for the 2013 tax year--you

have until April 15, the tax-filing deadline.

At first blush, funding an IRA might seem like one of those tasks that you should

be able to knock off in 10 minutes: pick your provider and the investments, fill out

the form, and send in your money. But some important decisions are embedded in

those simple tasks: whether to choose a Roth IRA or Traditional IRA, for example.

This week I'll tackle somemistakes that investors make

when it comes to their IRA

contributions. In a future

article, I'll discuss how it's

possible to go wrong with the

investments you choose to hold

inside your IRA.

Mistake 1: Waiting until the

last minute.

If you're rushing in your IRA contribution for the 2013 tax year, you're getting

tripped up right out of the box. And that's a big segment of IRA contributors: More

than double the amount of IRA contributions are made at the last minute (the

tax-filing deadline) than are made at the beginning of the tax year (in this case,

Jan. 1, 2013), according to Vanguard research on the topic. Over time, missing out

on the benefit of tax-advantaged compounding--even if it's only 15 months' worth

at a t ime--can add up to some serious money, according to Vanguard's research.

And even investors who fund their IRAs may delay in selecting their investments;

that too can weigh on returns over time, as discussed in this article. Younger

investors, in particular, should make a point of getting their IRA contributions

invested in long-term securities at the earliest opportunity.

Mistake 2: Thinking of it as an either/or decision: Roth versus Traditional.

Some investors might assume they need to be dogmatic about which IRA type they

choose: Roth or Traditional. But savvy investors often end up with a blend of

Traditional IRA and Roth accounts, both by happenstance and by design. For

example, someone who could contribute to a Traditional IRA in the past may no

longer be able to deduct her contribution because of income limits, but she can still

fund a Roth IRA. Moreover, the concept of tax diversification is a valuable one, and

argues for building balances in all three account types: taxable, tax-deferred

(Traditional IRA and 401(k)), and Roth. For one thing, few people can forecast

whether their tax rates will be higher or lower in retirement than they are now, so

holding multiple accounts is a good way to hedge against multiple outcomes.

Income levels while you're working may also fluctuate: A low tax-rate year can be

a good time to fund a Roth, while a deductible Traditional IRA contribution can be

more valuable when your tax rate is on the high side. In addition, holding taxable,

Roth, and tax-deferred accounts gives a retiree the ability to obtain varying tax

treatments of her withdrawals, thereby keeping taxable income lower. You can

even split your contributions among each account type in a single tax year, just so

long as your total contributions don't exceed the maximums ($5,550 for those

under 50 and $6,500 for those older than 50.)

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Mistake 3: Making a nondeductible IRA contribution for the long haul.

Contributing to a Traditional nondeductible IRA is the only available contribution

type for people who earn too much to fund a Roth IRA (and by extension earn too

much to deduct their Traditional IRA contribution because income limits are even

lower there). And opening a Traditional nondeductible IRA and then converting it

to a Roth IRA can be a valuable maneuver for many high-income savers because

there are no income limits on conversions. (More on this below.) But opening a

Traditional nondeductible IRA and leaving your money there--that is, not

converting those assets to a Roth--is almost never a good idea. Yes, the Traditional

nondeductible IRA gives you tax-deferred compounding, but you can also get that

by buying tax-efficient investments inside your taxable account. Moreover, the tax

treatment on long-held taxable assets (the capital gains rate) is more attractive

than the tax on IRA distributions, where you'll pay your ordinary income tax rate

on any money that hasn't been taxed yet.

Mistake 4: Assuming a Backdoor IRA contribution will be tax-free.

Although the nondeductible IRA isn't valuable as a buy-and-hold vehicle, it does

have some benefits as a conduit to a Roth IRA. The idea is that even if you earn

too much to contribute to a Roth IRA directly, you can open a Traditional

nondeductible IRA and convert it to a Roth; there is no income limit on Traditional

nondeductible IRAs or conversions. Assuming you have no other IRA assets, the

only tax you'll owe when you convert from Traditional to Roth will be on any

appreciation in the assets that occurred from the time you opened the account to

the time you converted.

However, the backdoor conversion may not be a good idea if you have other IRAassets that haven't been taxed yet--for example, money that you rolled over from

a Traditional 401(k) with a former employer. In that case, the taxes due on the

conversion will be based on the ratio of already-been-taxed IRA assets to those

that have never been taxed (pretax contributions, including Traditional 401(k)

rollover money, and investment earnings). If the former number is much smaller

than the latter, your conversion will be mostly taxable, as outlined here.

Mistake 5: Falling prey to analysis paralysis.

You practically need to be a certified financial planner or tax professional to get

your head around the maze of rules governing the various IRA types: Income

limits and tax treatment of contributions and withdrawals vary significantly. But

don't let the fear of selecting the wrong IRA wrapper keep you from making any

decision at all. If you make an IRA contribution that later proves ill-advised (for

example, you funded a Roth IRA when you earned to much to contribute to one),

you have a valuable escape hatch called recharacterization, essentially a do-over

for IRA investors. Recharacterization doesn't enable you to undo an IRA simply

because your investment choices were off the mark, but it does enable you to

switch to the IRA wrapper you should have chosen in the first place--Roth instead

of Traditional or vice versa.

Mistake 6: Not contributing later in life.

It's true that as you get older, any investment contributions will benefit less from

compounding than would contributions you made earlier in your investment

career. We've all seen the examples showing how the individual who starts at age

22 has $7 million at age 60, whereas the person who waited until age 40 to start

investing has about $12,000. (OK, I'm exaggerating.) In a related vein, IRA

contributions made later in life will benefit less from tax-free (Roth) or

tax-deferred (Traditional IRA) compounding than will contributions made earlier in

life.

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Comments 1-10 of 19 CommentsOldest First| Newest First

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That's not to say you should forget IRA contributions in the years leading up to and

during retirement, however. For one thing, you may have 20 years or more of

tax-advantaged compounding left. And if you're investing in a Roth IRA, you won't

need to take distributions from your account unless you need the money (that is,

there are no required minimum distributions), so your money could continue to

compound even after you're retired. Remember that you can start contributing an

extra $1,000 to an IRA at the beginning of the year in which you turn age 50 (for

a total contribution of $6,500). And even though you can't fund a Traditional IRA

once you've reached age 70 1/2, you can contribute to a Roth at any age, as long

as you or your spouse have enough earned income to cover the contribution

amount.


3/22/2014 1


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WillLana

14 hours, 50 minutes ago

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Thank you for an informative article

DefCompScott

15 hours, 53 minutes ago

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Pennccrn,

Everything I have read seems to indicate that, if the IRA Options

open to you are to contribute to a Roth or make non-deductible

contributions to a traditional, you should choose the Roth. As

discussed in Christine's article and earlier posts to this thread, you

get very little benefit from leaving the money in the non-deductible

traditional, and converting it to a Roth later (while perhaps more

beneficial than not) will likely not be as good for you as just

contributing it directly to the Roth. I personally would ONLY consider

making a non-deductible traditional contribution (and probably

convert it to Roth ASAP) if the Roth was not an option for me, and

even then I might just decide to go with a taxable account instead.

pennccrn

Mar 20 2014, 7:22 PM

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Hi all: I'm a newbie here, but perhaps someone can clarify what

would be the benefit on contributing to a Traditional IRA when you

exceed the income limits for a tax deduction. Shouldn't you just

divert these funds to a Roth IRA, if you qualify. I'm in the range

where I can contribute to both a Roth and Traditional IRA but can't

take the deduction of a traditional. Just curious, and please pardon

my ignorance.

dragonpat

Mar 20 2014, 11:55 AM

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"along with the extra 3.8% tax surcharge" unless you are talking

about something else, the 3.8% Medicare investment tax does not

apply to 401K or t-IRA withdrawals. Those withdrawals are taxed at

salary rates which get pushed into higher brackets as RMDs go on.

one can lessen future RMDs somewhat by converting to Roths at

such an amount per year that does not push you into the next tax

bracket.

joeBonnache

Mar 20 2014, 11:43 AM

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Christine, I have been reading all of your recent articles regarding

IRA strategy but have found the subject of withdrawal strategy to be

absent from these discussions. Common strategy suggests

postponement of IRA or SS as long as possible to maximize SS and

take full advantage of taxes by taking IRA distributions at 70 1/2.

However, I have many friends who now regret this strategy as theyhave a six figure hit to income that could have been lessened by a

more strategic approach to withdrawals. Large RMDs could lead to

far higher tax rates including higher Medicare charges along with the

extra 3.8% tax surcharge. For example, a single 60 year old with a

$750K balance could easily see their IRA balance double by the time

they reach 70 1/2. The 6.25% RMD required would lead to an

additional $90K in yearly taxable income .... Yikes! Besides the tax

hit, the realization that some of this money may have allowed a

better standard of living while one still has their health. There is a

good chance that you or your loved one will experience serious

health issues after 70, but before your death. After all .... Who cares

if you have millions if you are blind and cannot leave the house? I'm

looking to a compromise solution with gradual WD's starting at 60

and ramping up using a modified life expectancy calculation to ease

into my 70's. Enabling one to enjoy the fruits of their saving sacrifice

while lessening the shock of outsized RMDs. Any thoughts

(references) on this subject?

RalphN

Mar 19 2014, 12:46 PM

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I had been maxing out of my 401(k) contributions for a number of

years, for pre and post tax contributions. When the law was changed

in 2010, I converted those after tax contributions to a Roth (for the

actual contribution) and an IRA (for the profit from those after tax

contributions). There was no tax implication and now the Roth is

growing tax free. Is there a pitfall I might have missed?

Lengrav

Mar 17 2014, 12:18 PM

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I may add another potential error to your list. 5500 to a ROTH is not

the same as 5500 to a traditional IRA. I f a person is willing to do

5500 to ROTH they should be willing to do 5500 to traditional IRA

PLUS save the tax savings. Many will not save the savings.


3/22/2014 1


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M*_ChristineB

Mar 17 2014, 10:59 AM

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Hi all, and thanks for the comments thus far. I agree that it's too

complicated!

Rforno, the ability to take a deduction on an IRA contribution--or

tax-free withdrawals, in the case of Roth IRAs--gives them a benefit

that investing in a taxable account doesn't have.

Here's a l ink to a helpful chart on Bogleheads.org that compares

investments in various types of IRAs as well as a taxable account:

http://www.bogleheads.org/wiki/Non-deductible_traditional_IRA

Of course, it assumes that the investor's tax bracket stays static,

which often isn't the case. But I still think the illustration is useful.

Christine

dragonpat

Mar 17 2014, 10:37 AM

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"What's the point of this? Isn't the only way you can do this is to sell

periodically and thereby pay the tax even ear lier than you would

have had it piled up"

The ability to deduct Capital Losses is a huge advantage. Because of

the 3.8% Medicare investor Tax and the increase in State taxes, I

no longer am going to pay my taxes when gains reach 20%. I plan

to do it more piecemeal when I have capital losses. I do not hold

onto losses like I used to. I harvest them often and rebuy the same

asset after 32 days.

In Dec 2012 I harvested all my capital gains in my taxable account(no losses at that time), and paid the taxes on them before the

3.8% Medicare tax and the new higher state tax came online in

2013. In 2013, Some of these assets developed losses that I

harvested and used them to offset the taxes on my RSU stock

options rather than using post-tax cash from my slary. Those RSUs

are taxed at 33% by the feds, and 9.85% by the state.

I also donate highly appreciated stock to my church, get a tax

deduction for it, and then rebuy the asset.

One taxable account I share with my husband. It has primarily AAPL

stock in it that has appreciated something like 2250%. It pulls in as

great dividend but it get taxed at 25.8% by the feds and 9.86% by

the state. It is so appreciated now that unless AAPL goes to zero, we

can leave it for our children to inherit and it will step-up in value on

our deaths. it is possible in the future that I can generate some on

paper capital losses involving rental property and depreciation and

rescue some of it.

atomiccab

Mar 17 2014, 10:28 AM

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For many years I made a non-deductible traditional IRA

contribution. In 2010 I was finally able to convert to a Roth. I was

very happy I made those contributions now. I continue to maximize

my Roth space by converting new contributions every year. When I

retire a li ttle less than 20% of our assets will be in a Roth and 80%

taxable. I wish I had converted everything I had in 2010, but only

did about half. The new tax rules are astoundingly harsh for a

retiree who has worked hard and saved regularly for the last 40

years. I plan on doing everything legal to keep what I have earned

from the grasping government.

1-10 of 19 CommentsOldest First| Newest First


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