This week I'll tackle some mistakes 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 time--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.)
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 IRA assets 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 too 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.
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.
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