From contributions to conversions to distributions, don't fall into these traps.
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Note: This article is part of Morningstar's February 2016 Tax Relief Week special report. This article originally appeared Feb. 15, 2015.
For a vehicle with an annual contribution limit of just $5,500 ($6,500 for those over 50), investors sure have a lot riding on IRAs. Assets across all IRA accounts topped $7.4 trillion dollars in 2014, making the vehicle the top receptacle for retirement assets in the U.S., according to data from the Investment Company Institute. In addition to direct annual contributions, much of the money in IRAs is there because it has been rolled over from company retirement plans of former employers.
Opening an IRA is a pretty straightforward matter: Pick a brokerage or mutual fund company, fill out some forms, and fund the account. Yet, there are plenty of ways investors can stub their toes along the way. They can make the wrong types of IRA contributions--Roth or traditional--or select the wrong types of investments to put inside the tax-sheltered wrapper. And don't forget about the tax code, which delineates the ins and outs of withdrawals, required minimum distributions, conversions, rollovers, and recharacterizations. Rules as byzantine as these provide investors with plenty of opportunities to make poor decisions that can end up costing them money.
Here are 20 mistakes that investors can make with IRAs, as well as some tips on how to avoid them.
1) Waiting Until the 11th Hour to Contribute
Investors have until their tax-filing deadline--April 18 in 2016--to make an IRA contribution if they want it to count for the year prior. Perhaps not surprisingly, many investors take it down to the wire, according to a study from Vanguard, squeaking in their contributions right before the deadline rather than investing when they're first eligible (Jan. 1 of the year before). Those last-minute IRA contributions have less time to compound--even if it's only 15 months at a time--and that can add up to some serious money over time. Investors who don't have the full contribution amount at the start of the year are better off initiating an auto-investment plan with their IRAs, investing fixed installments per month until they hit the limit.
2) Assuming Roth Contributions Are Always Best
Investors have heard so much about the virtues of Roth IRAs--tax-free compounding and withdrawals, no mandatory withdrawals in retirement--that they might assume that funding a Roth instead of a traditional IRA is always the right answer. It's not. For investors who can deduct their traditional IRA contribution on their taxes--their income must fall below the limits outlined here--and who haven't yet save much for retirement, a traditional deductible IRA may, in fact, be the better answer. That's because their in-retirement tax rate is apt to be lower than it is when they make the contribution, so the tax break is more valuable to them now.
3) Thinking of It As an Either/Or Decision
Deciding whether to contribute to a Roth or traditional IRA depends on your tax bracket today versus where it will be in retirement. If you have no idea, it's reasonable to split the difference: Invest half of your contribution in a traditional IRA (deductible now, taxable in retirement) and steer the other half to a Roth (aftertax dollars in, tax-free on the way out).
4) Making a Nondeductible IRA Contribution for the Long Haul
If you earn too much to contribute to a Roth IRA, you also earn too much to make a traditional IRA contribution that's deductible on your tax return. The only option open to taxpayers at all income levels is a traditional nondeductible IRA. While investing in such an account and leaving it there might make sense in a few instances, investors subject themselves to two big drawbacks: required minimum distributions and ordinary income tax on withdrawals. The main virtue of a traditional nondeductible IRA, in my view, is as a conduit to a Roth IRA via the "backdoor Roth IRA maneuver." The investor simply makes a contribution to a nondeductible IRA and then converts those monies to a Roth shortly thereafter. (No income limits apply to conversions.) Note that the clock on backdoor Roth IRAs could be ticking: President Obama proposed closing the backdoor Roth IRA loophole in his most recent budget proposal, discussed here. For now, though, it's a viable maneuver for affluent retirement savers.
5) Assuming a Backdoor Roth IRA Will Be Tax-Free
The backdoor Roth IRA should be a tax-free maneuver in many instances. After all, the investor has contributed money that has already been taxed, and if the conversion is executed promptly (and the money is left in cash until it is), those assets won't have generated any investment earnings, either. For investors with substantial traditional IRA assets that have never been taxed, however, the maneuver may, in fact, be partially--even mostly--taxable, as outlined here.
6) Assuming a Backdoor Roth IRA Is Off-Limits Due to Substantial Traditional IRA Assets
Investors with substantial Traditional IRA assets that have never been taxed shouldn't automatically rule out the backdoor IRA idea, however. If they have the opportunity to roll their IRA into their employer's 401(k), they can effectively remove those 401(k) assets from the calculation used to determine whether their backdoor IRA is taxable. This article discusses the topic in greater depth.