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10 Missteps With Tax-Sheltered Accounts

Jason Stipp
Christine Benz

Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax Relief Week on, and today we're helping you maximize tax-sheltered accounts, specifically by avoiding some pitfalls in those accounts.

Here to talk about some of common mistakes, and uncommon mistakes, is Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: Christine, there are a lot of big mistakes that seasoned investors know, such as missing out on the company match in a 401(k), but you also have some maybe lesser-known mistakes that you can make in these accounts that could ultimately help investors save some tax dollars.

The first one is reflexively reaching for a Roth account. Roth accounts have a lot of great benefits, but they're not right in every single situation.

Benz: That's right. The keep profile for whom a traditional deductible IRA will tend to make the most sense is someone who is getting close to retirement and hasn't yet saved a lot. That person may in fact be in a higher tax bracket today than they will be when they are retired. In that case that tax deduction that you get when you make your contribution is going to be more beneficial for you than it will be in retirement. You may be in a much lower tax bracket in retirement than you are today.

Stipp: A possible second mistake can occur when converting assets from traditional IRAs to Roth. You need to be careful when you do that, especially if you have other traditional IRA assets.

Benz: That's right. It gets complicated. A lot of people have been enthusing about what's called the backdoor Roth IRA. That means that you open a traditional non-deductible IRA and then you convert that to a Roth. You can do that at any income level, which is why it has gained some excitement among higher-income investors.

The key thing you need to be aware of is, if you have other IRA assets, traditional IRA assets, that have not been taxed yet, the tax treatment that you'll incur when you do that conversion will be based on your ratio of monies that have never been taxed to new IRA assets. So you want to be careful. You may want to check with a tax advisor to see whether that backdoor Roth idea makes sense for you.

Stipp: Another mistake when it comes to doing these conversions is thinking that it's an all-or-nothing prospect--that you have to convert every single bit of your traditional IRA to Roth--but that's not the case.

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Benz: It's not the case at all. I think people can really get a lot of mileage out of doing partial conversions, which are completely allowable. The beauty of a partial conversion is that you can convert just enough so that you don't push yourself into a higher income-tax bracket for the year in which you do the conversion.

Work with an accountant on this. If you have a lot of IRA assets that you want to convert, it can be a great strategy to do it piecemeal over a period of many years. Also bear in mind that you do have an escape hatch. You can do a re-characterization--essentially a do-over--if you do a conversion and the timing in hindsight turns out not to have been right.

Stipp: The next mistake that some investors might make, or maybe a lot of investors, is waiting until the last minute to fund an IRA account for the prior tax year. Why might you not want to wait until early April 2014 to do your 2013 contribution to an IRA account?

Benz: Incidentally, that's what Vanguard has found. When it looked at when people have contributed, it found that a lot of people rush the doors right before that tax-filing deadline.

Foregone compounding is really the main reason that you don't want to do that. Think back to the beginning of 2013; if you had only made that contribution at the outset of 2013 instead of waiting until now to make it, you would have had a year's worth of great appreciation. This is particularly important for younger folks with longer time horizons. That benefit of compounding when multiplied over many years can really add up.

Stipp: Turning to 401(k) plans: Of course a big mistake is not at least contributing enough to get your employer match, but when you contribute can also affect the kind of match that you get, and people can miss out on a match in certain situations.

Benz: That's right. This is kind of a high-class problem. It's something that higher-income people sometimes run into, where they max out their 401(k) plans very early in the year. What happens is that they haven't taken full advantage of employer matching contributions, which are usually spaced out on a per-pay-period basis. So you want to be careful: If you've earned a bonus and you're contributing at a very high level, you could actually not benefit from your full employer matching contributions.

Some plans have instituted a provision that actually will give employees full matching if they have maxed out their contributions, even if they've done so in the first part of the year. But check with your plan. If your plan does not have such a provision, you want to be careful to space out your contributions pretty evenly.

Stipp: Mistake number six involves not considering how a possible Roth 401(k) option could be beneficial for you when you do reach retirement.

Benz: For a lot of people, splitting the difference between traditional 401(k) contributions and Roth 401(k) contributions can be the way to go, because really what you have to decide when you choose which type of contribution to make is what sort of tax bracket you will be in during retirement versus where you are now. A lot of people say, I have no idea--especially younger earners. For them, splitting between the two account types, which is usually an allowable option, is the way to go.

Stipp: Another mistake involves a different kind of tax-sheltered account, the HSA or the health savings account. Some investors may say, I'm not going to use the HAS; it's not for me. But there could be benefits for some folks here.

Benz: Health savings accounts are used in conjunction with high-deductible health-care plans. A lot of people might say, I don't want to pay the deductibles out of pocket, or it's just more complicated than investing in the traditional health-care plan, and that's all true.

But particularly people who are healthy and wealthy--so, who are already maxing out their other tax-sheltered vehicles and are in pretty good health, and probably won't have a lot of out-of-pocket health-care costs--for them, HSA can be a really nice tool in their toolkit.

In particular, it has three tax-saving benefits. You make pretax contributions, you enjoy tax-free compounding on the money, and then assuming that the withdrawals are for qualified health-care expenses, that money is tax-free, too. So it's one of the only triple-tax-benefited accounts in the whole tax code.

Stipp: Mistake number eight also involves 401(k) plans, and that's automatically rolling over the 401(k) to an IRA when you retire or when you switch jobs. There are a lot of good reasons to do that, but there are also some reasons to keep money in the 401(k) plan in certain circumstances.

Benz: I often say the rollover is the best answer in part because you can get away from that extra layer of fees that accompanies a 401(k) plan and isn't there with an IRA. But if you are in one of a couple of different categories, you want to steer clear of the rollover and instead stay put in the 401(k).

The first is if a lot of your 401(k) assets are in company stock: Check with an accountant on this, but oftentimes it will be better to leave that money in the 401(k), because you'll be able to enjoy capital gains treatment on the money when you begin withdrawing it in retirement.

The other category is for people who are between age 55 and 59 1/2 and they want to begin withdrawing money from the 401(k) during that time period. They may be able to begin withdrawing from the 401(k) before age 59 1/2; they can't do that from an IRA without incurring a 10% penalty.

Stipp: A couple of portfolio planning mistakes: The first one is not thinking about your asset location, or what types of investments you put into these accounts.

Benz: You want to keep in mind that you do enjoy tax-free or tax-deferred compounding on your money. In general, if you have any sort of investment types that are kicking off a lot of ordinary income, you want to make sure that you're housing them within tax-sheltered accounts. You can hold other types of assets--like index funds, for example, or municipal bond funds--in your taxable accounts because they will tend to be very tax-friendly on a year-to-year basis.

So keep in mind that concept of asset location when you think about which types of investments to place where.

Stipp: But sometimes that asset location can change, especially as you move into retirement?

Benz: That's right. So, in particular, you'd want to think about getting bonds relocated into your taxable accounts because those are typically the first accounts you'd want to deplete in retirement.

Stipp: So, there can be some twisting that happens as you get into retirement.

Benz: Exactly.

Stipp: The last mistake is not using taxable accounts. Even if you have tax-deferred accounts, there are some reasons that you might want to have taxable accounts, especially when you get into retirement?

Benz: That's right. One of the key reasons is that for some people--especially, again, people who are in the higher-income bands--putting the full contribution into the IRA and 401(k) just may not be enough given your income demands in retirement. You will need to use taxable vehicles as well.

The other key reason to consider it is that, when you are actually retired and you're beginning to withdraw those assets, you can really be quite strategic about where you go for cash--which of your account types you'd tap for cash. And those taxable vehicles, especially if you are paying a lot of attention to what types of assets you're putting there, can be pretty tax-friendly on a year-to-year basis.

If you find yourselves in a very high-tax year and need to pull some money out, you may be able to enjoy pretty low capital-gains treatment on the money that's coming out of those taxable accounts. So, definitely tax diversification is a goal for people who are getting close to retirement.

Stipp: Christine, the tax-sheltered account is one of the most important tools in investors' toolkits. Thanks for helping us use those better today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.