• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Investment Insights>20 IRA Mistakes to Avoid

20 IRA Mistakes to Avoid

From contributions to conversions and distributions, don’t let clients fall into these traps.

Christine Benz, 08/08/2017

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 $7.5 trillion in 2014, making the vehicle the top receptacle for retirement assets in the United States, 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. 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 in April to make an IRA contribution if they want it to count for the year prior. Many investors take it down to the wire, according to a Vanguard study, 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 and who haven’t yet saved 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 one’s tax bracket today versus where it will be in retirement. If that is hard to predict, it’s reasonable to split the difference: Invest half of the contribution in a traditional IRA and steer the other half to a Roth.

4 Making a Nondeductible IRA Contribution for the Long Haul
If investors earn too much to contribute to a Roth IRA, they also earn too much to make a traditional IRA contribution that’s deductible on their 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, or RMDs, 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.)

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 be taxable.

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.

7 Not Contributing Later in Life
True, investors can’t make traditional IRA contributions after age 70 1/2. They can, however, make Roth contributions, assuming they or their spouse have enough earned income (from working, not from Social Security or their portfolios) to cover the amount of their contribution. Making Roth IRA contributions later in life can be attractive for investors who don’t expect to need the money in their own retirements but instead plan to pass it on to their heirs, who in turn will be able to take tax-free withdrawals. (Roth IRAs aren’t subject to RMDs.)

8 Not Gifting for IRAs
Speaking of earned income, as long as a kid in your life has some, making a Roth contribution on his or her behalf (up to the amount of the child’s income) is a great way to kick-start a lifetime of investing. Per the IRS’ guidelines, it doesn’t matter whether the child puts his or her own money into the IRA. What matters is that the child’s income was equal to or greater than the amount that went into the account.

9 Forgetting About Spousal Contributions
Couples with a nonearning spouse may tend to short-shrift retirement planning for the one who’s not earning a paycheck. That’s a missed opportunity. As long as the earning spouse has enough earned income to cover the total amount contributed for the two of them, the couple can make IRA contributions for both individuals each calendar year. Maxing out both spouses’ IRA contributions is, in fact, preferable to maxing out contributions to the earning partner’s company retirement plan if it’s subpar.

10 Delaying Contributions Because of Short- Term Considerations
Investors—especially younger ones—might put off making IRA contributions, assuming they’ll be tying their money up until retirement. Not necessarily. Roth IRA contributions are liquid and can be withdrawn at any time and for any reason without taxes or penalty. Investors also may withdraw the investment-earnings component of their IRA money without taxes or penalty under very specific circumstances. While it’s not ideal to raid an IRA prematurely, doing so is better than not contributing in the first place.

11 Running Afoul of the Five-Year Rule
The ability to take tax-free withdrawals in retirement is the key advantage of having a Roth IRA. But even investors who are age 59 1/2 have to satisfy what’s called the five-year rule, meaning that the assets must be in the Roth for at least five years before they begin withdrawing them. That’s straightforward enough, but things get more complicated—too complicated to explain in this space—if money is in a Roth because it was converted from traditional IRA assets. Do the research.

12 Thinking of an IRA as ‘Mad Money’
Many investors amass sizable sums in their 401(k)s before they turn to an IRA. Thus, it might be tempting for them to think of the IRA as “mad money.” Don’t let them fall into that trap. While an IRA can be a good way to capture asset classes that aren’t offered in a company retirement plan, ongoing contributions to the account, plus investment appreciation, mean that an IRA can grow into a nice chunk of change over time. Thus, it makes sense to populate it with core investments from the start, rather than dabbling in niche investments that don’t add up to a cohesive whole.

13 Doubling Up on Tax Shelters
In addition to avoiding narrow investments for an IRA, it also makes sense to avoid any investment type that offers tax-sheltering features itself. That’s because investors are usually paying some kind of a toll for those tax-saving features, but they don’t need them because the money is inside of an IRA. Municipal bonds are an example of what not to put in an IRA; their yields are usually lower than taxable bonds’ because that income isn’t subject to federal—and in some cases, state—income taxes. Master limited partnerships are also generally a good fit for a taxable account, not inside of an IRA.

14 Not Paying Enough Attention to Asset Location
Because an IRA gives investors some form of a tax break, it’s valuable to make sure they’re taking full advantage of it. Higher-yielding securities such as high-yield bonds and REITs, the income from which is taxed at investors’ ordinary income tax rates, are a perfect fit for a traditional IRA, in that those tax-deferred distributions take good advantage of what a traditional IRA has to offer. Meanwhile, stocks, which have the best long-run appreciation potential, are a good fit for a Roth IRA, which offers tax-free withdrawals.

15 Triggering a Tax Bill on an IRA Rollover
A rollover from a 401(k) to an IRA—or from one IRA to another—isn’t complicated, and it should be a tax-free event. However, it’s possible to trigger a tax bill and an early withdrawal penalty if investors take money out of the 401(k), with the intent to do a rollover, and the money doesn’t make it into the new IRA within 60 days.

16 Not Being Strategic About Required Minimum Distributions
RMDs from traditional IRAs, which start after age 70 1/2, are the bane of many affluent retirees’ existences, triggering tax bills they’d rather not pay. But such investors can, at a minimum, take advantage of RMD season to get their portfolios back into line, selling highly appreciated shares to meet the RMDs and reducing their portfolios’ risk levels at the same time.

17 Not Reinvesting Unneeded RMDs
In a related vein, retired investors might worry that those distributions will take them over their planned spending rate from their portfolios. (RMDs start well below 4% but escalate well above 6% for investors who are in their 80s.) The workaround? They can invest in a Roth IRA if they have earned income or—more likely—in tax-efficient assets inside of a taxable account.

18 Not Taking Advantage of Qualified Charitable Distributions
RMD-subject investors also miss an opportunity if they make deductible charitable contributions rather than directing their RMDs (or a portion of them) directly to charity. That’s because a qualified charitable distribution reduces adjusted gross income, and that tends to have a more beneficial tax effect than taking the deduction.

19 Not Paying Enough Attention to Beneficiary Designations
Beneficiary designations supersede expensive, carefully drawn-up estate plans, but many investors scratch them out with barely a thought, or make them once but don’t revisit them ever again. Know the pros and cons of leaving an IRA to a spouse, children, and grandchildren.

20 Not Exploring Options on an Inherited IRA
Inheriting an IRA can be a wonderful thing, but it’s not as simple as it sounds. The inheritor will have different options for what to do with the assets depending on his or her relationship to the deceased. The inheritor can inadvertently trigger a big tax bill by tapping the IRA assets without knowing the rules on inherited IRAs.

This article originally appeared in the August/September 2017 issue of Morningstar magazine.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

©2017 Morningstar Advisor. All right reserved.