The Error-Proof Portfolio: Dollar-Cost Average or Invest a Lump Sum in an IRA?

It's IRA season. Of course, technically you can invest in an IRA any time you want--at the beginning of a given tax year, when you get your bonus, or on April 15 just as you turn in your tax return for the year prior. (You have until your tax-filing deadline to make an IRA contribution that will count toward the previous year.) 

In reality, however, many IRA investors rush their contributions in right around tax time, so that they can deduct their contribution on their tax return for the year just past or, if they're not eligible for a deduction, so that the contribution can count toward their maximum allowable contribution for that prior year.

Yet as commonplace as the practice is, waiting until the last minute to contribute to an IRA should definitely be on your list of what not to do. You don't need any additional to-dos around tax time, of course. Even more important is that waiting until April 15 also means you've given short shrift to your retirement portfolio of 16 months' worth of compounding. For example, someone who invested $5,500 in an IRA consisting of a total stock market index on Jan. 1, 2013. would have almost $7,000 now. And the person who waited it out in cash would have $5,525 or thereabouts, depending on whatever miserly interest rate was available. 

Of course, the market won't be nearly as strong every year as it was in 2013. Some years it will be down, and you'll wish you had waited. But given that the market generally trends up over longer time frames, delaying contributions until the last minute rather than getting them into your account as soon as you can will drag on your portfolio's value. 

But does that mean lump-sum IRA contributions at the beginning of each calendar year are always a good idea? After all, there's a whole body of financial literature that points to dollar-cost averaging as a helpful tool, not so much in terms of return enhancement--as my colleague Adam Zoll explored in this article--but because dollar-cost averaging helps on the risk-reduction front. 

The decision about whether to send the whole $5,500 (or $6,500 if over 50) contribution into an IRA on Jan. 1 of the new tax year or space your contributions out during the year depends a lot on you: your attitude toward short-term volatility, your time horizon, and the valuation of what you're investing in, among other factors. Here are some guidelines to help you make the right call.

Invest a Lump Sum if You:
Haven't yet contributed for the preceding tax year. It goes without saying that if the new tax year has started and you haven't yet made a contribution for the previous year, you're better off getting the money into your IRA account as soon as possible. If your dollar-cost averaging time horizon is only a few months, spacing out your contributions over such a short time period is not going to deliver a big risk-reduction benefit, so you may as well put the money to work. And even if it seems like a particularly bad time to put a lump sum to work in a given investment because of valuation considerations (see below), you can always park the money in cash inside of an IRA and dribble it into the market during the next few months.

Are investing in a multi-asset-class vehicle. If you're investing in a balanced fund or a target-date vehicle with significant exposure to bonds, you're already obtaining some risk-reduction benefits. Because you're diversified across two asset classes whose performance paths tend to move in opposite directions, you have less of a need for the time diversification that accompanies a dollar-cost averaging program. And annual contribution limits on an IRA already instill a risk-reducing form of dollar-cost averaging--albeit on a yearly basis rather than on a monthly or quarterly basis. Even if the stock piece of your IRA holding goes straight down after you make your contribution, your balanced funds' bond holdings might go up. 

Are doing a backdoor Roth IRA. The backdoor Roth IRA maneuver enables higher-income workers who are otherwise ineligible to make a direct Roth contribution to obtain Roth status on their accounts. To do so, they simply need to open a Traditional nondeductible IRA and convert those monies to Roth shortly thereafter; their only taxes due would be based on any investment earnings on the money they originally invested. Because cost basis factors into the taxes due upon conversion, making a lump-sum investment to the Traditional IRA before converting will tend to be less cumbersome from an accounting paper-trail perspective than dollar-cost averaging. 

Have a very long time horizon. The longer your investing time period, the more likely it is that you'll accrue benefits by investing in the early part of each year rather than waiting until the end--and the less you ought to concern yourself with the short-term volatility that may accompany a single lump-sum investment. Yes, you may make the occasional lump-sum investment that turns out to be ill-timed. But over time the benefits of getting that money invested earlier will tend to offset the drag of making one or two lump-sum purchases that went on to drop precipitously. And even if your time horizon before tapping your IRA is pretty short, your new contributions may be a small portion of your IRA kitty, so the negative effects of making an ill-timed, single lump-sum purchase are unlikely to be that great.

Dollar-Cost Average Into an IRA If You:
Think that market valuations look exceptionally lofty. One of the best reasons to space contributions out throughout the year is if the market--or the specific investment you'd like to put inside your IRA--looks particularly expensive at current levels. Lofty valuations heighten the risk of a market downturn, and as my colleague Adam Zoll discusses in this article, you're better off dollar-cost averaging in down markets than you are in rising ones. Before you hold off on a lump-sum contribution because you think something is expensive, however, make sure you're anchoring that assessment in real numbers rather than basing your actions on bearish chatter. Morningstar's Stock Analyst Reports provide price/fair value ratios for individual companies under coverage, and this graph helps you see the aggregated price/fair value for the companies in our analysts' coverage universe. As of Jan. 31, stocks were trading roughly in line with the analysts' fair value estimates, neither egregiously over- nor undervalued.

Are investing in something that's extremely volatile. In a related vein, if the investment you're targeting for your IRA tends to be exceptionally volatile--a precious-metals equity fund, for example--dollar-cost averaging into your position to obtain a range of purchase prices can make good sense.

Are a nervous investor. Dollar-cost averaging can also be a good idea if you have a history of letting your nerves get the best of you in volatile markets. If you know you might be tempted to swap into a certificate of deposit if the you see the $5,500 in your IRA take a big hit right out of the box, you're better off dollar-cost averaging.

Can't swing a lump-sum investment. Yet another factor in favor of dollar-cost averaging is that investing smaller sums at regular intervals is often more budget-friendly than coming up with a big chunk of change at the beginning of each year. If spacing the contributions throughout the year (provided your IRA provider allows you to do that) is the most painless way for you to make a full contribution to your IRA, by all means sign up for an automatic investment plan. If you're under 50 years old, that means you can contribute $458 per month; those over 50 can contribute $542.

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