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By Christine Benz and Jeremy Glaser | 02-01-2017 02:00 PM

Last-Minute IRA Contribution Can Cost You

Waiting until April to make your contributions can lead to missed opportunity. Plus, tips about backdoor Roth IRAs and the benefits of spousal IRAs.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As tax day approaches, many investors are thinking about making their 2016 IRA contributions. I'm here today with Christine Benz, she's our director of personal finance, for some tips.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: So, one of the first pieces of advice you have is that you really shouldn't wait all the way until that last minute to contribute to the prior year's IRA.

Benz: That's right. I have done this, I don't know if you've done this, Jeremy. 

Glaser: I've done it, too, yes.

Benz: But certainly, when we look at fund companies, when they look at where the inflows come in, or when the inflows come in, Vanguard has said that it receives double the amount of contributions in April than any other month. So, people are clearly waiting until the last minute, until that tax filing deadline to make their IRA contributions.

The problem is, especially if you are a younger investor with a long runway to retirement, you are facing an opportunity cost by waiting until the last minute to steer some money into the IRA. So, I know from a practical standpoint, it can be really difficult to come up with that full IRA contribution that you are eligible to make Jan. 1 of a given tax year.

But at a minimum I think it makes sense to dollar-cost-average into that IRA over the course of a year. That also makes it more likely that--when that deadline is actually here--that you'll actually have at least funded part of the IRA. So. I think it's a good strategy to dollar-cost-average, or best case scenario, get that money working for you at the outset of a tax year. So, if you want to make a 2017 IRA contribution do it as soon as possible.

Glaser: And when you make that contribution, make sure it's actually invested and not just sitting in cash.

Benz: That's right. This is another finding from Vanguard. When it examines IRA contributor behavior, it shows that a lot of investors are just trying to get that contribution in. They don't actually take that next step of getting the money invested. So, lot of people park the money in a money market account, and then it takes them a few months to actually put the money into something. I think it does make sense to be deliberate about where you put that IRA contribution, particularly given that we've come off this, we're in the midst of this great equity market rally. But one idea is, maybe to buy the target-date fund while you figure out where the optimal holding spot for that IRA is, rather than just let it sit fallow in cash, which as you know, is earning next to nothing right now.

Glaser: For a lot of investors, particularly those just getting started, there can be such bewildering number of investments though. How do you narrow down that universe to figure out what to put that money in?

Benz: The best starting point in my view is to take a view, take an X-ray view of your portfolio, look at where your asset allocation is relative to reasonable targets for someone in your same age band. Use that as a starting point. And I think that that can be a great piece of intelligence as you figure out what to do with your IRA.

So certainly, for many investors who are getting older and getting close to retirement, adding to bonds may be the right answer for their new IRA contributions. For younger investors who still have very equity-heavy portfolios perhaps adding to their foreign stock holdings is a way to think about allocating new IRA assets. But use your asset allocation to guide where you put those contributions.

Glaser: And don't forget to look at it across all of your accounts, not your retirement, not just that one account.

Benz: That's right, and that's why I love that X-ray tools that you are able to enter all of your holdings, all of your retirement assets--yours and your spouse's--and you are able to see, well, here is where we are, and then compare that to some reasonable targets.

Glaser: And you say don't be afraid to keep it very simple.

Benz: No. Some investors gravitate to broad market equity index funds for the core of their portfolios. These holdings are particularly tax efficient so they are often held out as the perfect thing to put within your taxable account, but by all means that plain-vanilla core index fund can make a lot of sense for your IRAs as well.

Glaser: Now lot of investors think that they make too much money to qualify for IRA contribution. But they should keep that backdoor Roth IRA in mind.

Benz: Absolutely. So, this is a maneuver that people have been talking about since 2010 when the income limit on IRA conversions was dropped. So, the basic idea is that you fund a traditional nondeductible IRA, anyone can contribute to such an IRA regardless of income level. So, you fund that IRA and then before too much time has elapsed you convert it to a Roth IRA. So, you have those Roth IRA assets that can begin working for you for retirement. And then in retirement, you can take tax-free withdrawals. The big caveat with this strategy--and I know it's one that we've talked about before, Jeremy--is if you have a lot of other traditional IRA assets at the time you convert that small IRA kitty to Roth, that event might be more taxable then you imagined. So, check into that before you embark on this backdoor Roth IRA strategy. It's generally not going to be a good strategy for people with lot of other traditional IRA assets, especially rollover IRA assets.

Glaser: And Roth IRA might not be the right choice for everyone anyway?

Benz: Well, that's the thing. I think investors have heard so much about Roth IRAs, and certainly there is a lot to be said for that ability to take tax-free withdrawals in retirement, there's lot that's really compelling about that. But it's not the right type of IRA for each and every person. In particular, for people who are getting closer retirement and they haven't yet amassed much in retirement savings, well it's a good bet that if they can deduct their contribution to a traditional IRA, that's the right time for them to take a tax break while they are still working. Their income is likely to be higher during their employed years than it is apt to be when they are retired. So, that traditional deductible IRA--assuming that their income is below the levels for deductibility--can make more sense than the Roth IRA.

Glaser: And finally, consider spousal IRA.

Benz: I think this is often overlooked. I know, I have a lot of friends who are part of single-earner couples, and I think sometimes they overlook the opportunity to get a little bit into the nonearning-spouse's retirement kitty. So as long as the earning spouse has enough income to cover both spouses' income, you can make another IRA contribution on behalf of the nonearning spouse. So, I think this is certainly a strategy worth considering for couples, where you've maybe got one person who is out of the workforce raising children or whatever it might be, it can make a lot of sense to try to build up assets for the couple together as well as for the nonearning spouse.

Glaser: Christine, thanks for your tips today.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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