10 Missteps With Tax-Sheltered Accounts

Most seasoned investors know the big mistakes to avoid in tax-sheltered accounts--such as failing to get your employer match in a 401(k)--but those who aren't well-versed in Roth conversions, health savings accounts, or rollovers could end up leaving substantial money on the table (or paying more tax than they had to).

As part of Morningstar's Tax Relief Week, our director of personal finance Christine Benz ticked off 10 mistakes that could cost you in your tax-sheltered accounts.

IRAs
Mistake 1: Reflexively reaching for a Roth
Roth accounts have a lot of great benefits, but they're not right in every single situation. 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, the tax deduction that you get when you make your contribution is going to be more beneficial for you than it will be in retirement, because you may be in a much lower tax bracket in retirement than you are today.

Mistake 2: Bolting through a "backdoor" Roth IRA conversion
A lot of people have been enthusing about what's called the backdoor Roth IRA. That means you can 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 traditional IRA assets, which 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.

Mistake 3: Taking an all-or-nothing approach to conversions from traditional to Roth IRA
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 recharacterization--essentially a do-over--if you do a conversion and the timing in hindsight turns out not to have been right.

Mistake 4: Waiting until the last minute to fund an IRA
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. The benefit of compounding when multiplied over many years can really add up

401(k)s and HSAs
Mistake 5: Missing matching contributions because you didn't space them out
This is 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.

Mistake 6: Forgoing a Roth 401(k)
For a lot of people, splitting the difference between traditional 401(k) contributions and Roth 401(k) contributions can be the way to go. 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.

Mistake 7: Missing the triple benefits of health savings accounts (HSAs) ... if they're right for you
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 an HSA is just more complicated than investing in the traditional health-care plan, and that's all true.

But particularly people who are healthy and wealthy--those who are already maxing out their other tax-sheltered vehicles, are in pretty good health, and probably won't have a lot of out-of-pocket health-care costs--for them, HSAs 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. It's one of the only triple-tax-benefited accounts in the whole tax code.

Mistake 8: Automatically rolling over your 401(k)
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 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.

Portfolio Planning
Mistake 9: Not minding your asset location
You want to keep in mind that you do enjoy tax-free or tax-deferred compounding on your money in a tax-sheltered account. 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.

But that asset location can change, especially as you move into retirement. In particular, you will want to think about getting bonds relocated into your taxable accounts in retirement because those are typically the first accounts you'd want to deplete.

Mistake 10: Not diversifying with taxable accounts
One of the key reasons for holding a taxable investment account in addition to an IRA or 401(k) 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 a taxable account 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 tap. 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 yourself 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. On the other hand, withdrawals from traditional IRAs or 401(k)s will be taxed at your ordinary income-tax rate. So, tax diversification should definitely be a goal for people who are getting close to retirement.