Jason Stipp: I am Jason Stipp for Morningstar and welcome to the Friday Five. We're in the thick of IRA season as investors are making their IRA contributions before the tax filing deadline.
Here with me to keep you on the IRA highroad and avoid some IRA tax pitfalls is Morningstar's Christine Benz, director of personal finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: So we do want to make sure we get those IRA contributions in before April 17 for the 2011 tax year, but there are a few things to keep in mind--some pitfalls to avoid, and just some things to make sure you are maximizing the value of these accounts.
The first one has to do asset location. This is something that we've written about before. There are certain tax benefits to IRAs, you want to make sure you maximize them and that has to do with what kinds of assets you put in them.
Benz: It does Jason, and so the key feature that you're getting with an IRA of any kind is that you're getting tax-deferred compounding. So you're not going to have to pay taxes on that money from year-to-year. So anything that does have a high tax cost that you might hold in a taxable account is going to be a good holding for an IRA. So anything that kicks off a lot of current income or short-term capital gains, both of which are taxed at your ordinary income tax rate, the highest rate, you'd want to make sure to keep within the confines of an IRA. Just take advantage of that tax-sheltered compounding that you're getting.
Stipp: Christine, say I am a younger investor, and I'm just starting out, I'm not likely to necessarily have or want to have a lot of income-paying investments in a long-term account like an IRA. How should I think about the tax advantage then?
Benz: That’s a really good point Jason. So, I don’t think you need to go out of your way to buy income-producing investments, if you don’t really need them. If you're 22, you probably want to have the bulk of your assets in stocks at that point. So you don’t want to put the tax cart before the horse. Let your overall asset allocation plan dictate what you have in your various accounts, but don’t go searching for income-producing investments that you might not really need.
Stipp: We do know that IRAs are pretty open; you can put a lot of different kinds of assets in them, but there is one especially popular type of investment right now that you probably should keep out of your IRA.
Benz: That’s right, and it's a hot one among a lot of our readers. This is MLPs, and they are actually best situated within the confines of a taxable account because they make kick off what's called unrealized business taxable income. If that amount exceeds $1,000, it will be taxable within an IRA. And so, you do just want to be careful. In most cases, [MLPs] will make the most sense for your taxable accounts.
Stipp: Christine, number two IRA mistake to avoid has to do with a lot of folks thinking that the IRA is not for them anymore. Maybe they are in retirement and they think this is a saving for retirement vehicle. Or maybe they are not working full time anymore. But that doesn’t necessarily mean that you can’t invest in an IRA?
Benz: Right, so we'll take a couple of these categories. First off folks who are older, even you are over age 70 1/2, well you cannot contribute to a traditional IRA, you can continue to make Roth IRA contributions as long as you have enough earned income, not income from your investments, enough earned income to cover your IRA contribution. And it needn’t be your own income. If your spouse has enough income to cover a contribution for maybe both you and your spouse, then that’s OK. You can go ahead and make your contributions.
The same goes for individuals--maybe stay-at-home parents, for example--who aren’t earning income. As long as the spouse has enough earned income to cover the amount of the contribution, those people can also make contributions. So don’t rule it out even if you aren’t earning that paycheck yourself; your spouse's paycheck should be able to cover your own contribution.
Stipp: Christine, IRA mistake number three has to do with something we've written a lot about, which is converting a traditional IRA to a Roth IRA. There are lots of opportunities here, but there is one important thing that investor should really consider before they undertake that conversion.
Benz: The key thing is if you've got other IRA assets over to the side, you really need to step back and think about what types of contributions exist within the confines of those IRAs. So the reason is, if you have deductible IRA contributions or maybe money that you've rolled over from a 401(k) plan, sitting on the side in another IRA, that will affect the tax bill that you will pay when you do a conversion of your new IRA.
Stipp: Even if you're not intending to convert that other pool, it could potentially affect [your tax liability]...
Benz: Right. So it's just sitting there. So to use an example, say I've opened a new non-deductible IRA, and my goal is to convert that to a Roth. So I've got my new $5,000 contribution, but over here, I've got a rollover IRA from a previous employer, and say that's $20,000.
In the IRS' eyes, when I go to convert my $5,000, the IRS says, "Well, you've got $20,000, or 80% of your overall IRA kitty, in money that you haven't paid taxes on. So for any conversions that you do, we are going to tax you on that percentage of your total IRA pool that consists of deductible contributions, or money that you haven't paid taxes on.
So in this case, of my $5,000 contribution, the only one that I want to convert, $4,000 of that would actually be taxable when I do that conversion. So that could, chances are, trigger a much higher tax bill than you would have ever anticipated.
Stipp: Very, very important advice, Christine.
The next one also has to do with the conversion to a Roth IRA. If you do undertake the conversion from regular IRA to a Roth IRA, you actually have a way that you could do it over again in certain kinds of market conditions. When would you want to do it, and who would be eligible to do that?
Benz: This is a really generous provision, Jason. It's called a recharacterization. So if for whatever reason you've made one type of IRA contribution--so maybe I and my spouse made Roth IRA contributions and found that we earned too much to qualify for Roth IRA contributions, we can recharacterize back to traditional non-deductible contributions, and then maybe think about executing one of these backdoor IRA maneuvers. But you have some ability to change up the nature of the contribution.
And this can be particularly important if you have done a conversion from traditional IRA assets to Roth, and you've paid the tax bill that was due when you did that conversion, but your securities have gone down in price since you did that conversion, and so you essentially paid more taxes than you really needed to. You could recharacterize back to traditional IRAs, and at some point think about converting at a more advantageous price, where your tax bill would be lower.
Stipp: Is there a deadline for doing that? So let's say I did the conversion last year and then securities have really dropped, and I'd like to do that recharacterization. When do I have to have it done by?
Benz: So the deadline is the tax filing deadline for the year in which you either made the contribution or did the conversion. So in the case of contributions and conversions done in 2011, it would be this coming April 17.
Stipp: So if I had done a conversion several years ago, I've missed the bus on this potential opportunity?
Benz: Unfortunately, yes.
Stipp: So mistake number four is forgetting about the recharacterization, which could be very important for some investors.
And lastly, mistake number five is maybe pertinent to younger investors. These are folks who, maybe they thought about the Roth IRA, but they have some uncertainty in their household or they're worried that they might need some of that money, and so they are [reluctant to] put [money] into a retirement account right now. [They think they] need flexibility to have that money. But that could be a mistake.
Benz: I think it could. So first, I want to be clear. I don't think you want to be using a Roth IRA as a substitute for an emergency fund. This should be money that you at least have some plan of having grow and compound for retirement. But ... the Roth vehicle does offer a tremendous amount of flexibility in that you can withdraw those contributions at any time and for any reason. So even if it turns out that you do need that money maybe for a first-time home purchase or whatever it might be, you can at that money, and you won't have to pay any penalties or taxes. You've already paid tax on that money that you're contributing. So the IRS doesn't levy any additional costs. So it's pretty flexible.
Stipp: In fact, I know that the IRS also has a few exceptions where you actually could tap some of the earnings if you meet certain requirements?
Benz: That's absolutely true, and it's also the case for taping traditional IRAs as well. There are certain situations in which you may be able to skirt some of the penalties: So first-time home buying, disability, college expenses, and so forth. So check out the IRS' publications on what the possibilities are for prematurely withdrawing parts of your IRA.
Stipp: Certainly these are intended as very long-term accounts, but it's good to know that you have some flexibility in some cases if you need it.
Christine, some very important IRA mistakes to avoid in the middle of IRA season. Thanks so much for joining me.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.