7 Myths That Could Trip Up IRA Contributors

IRS Publication 590--the one that details the rules on various types of IRAs--is a full 62 pages long. It includes the skinny on Roth, Traditional, SIMPLE, spousal, inherited, and SEP IRA accounts, as well as details about conversions, conduits, recharacterizations, required minimum distributions, and withdrawals.

Is it any wonder so many investors face analysis paralysis when it comes to deciding what type of IRA to invest in and what to put inside of it? The complexity of all of those IRA rules also leaves open room for a lot of shorthand advice that, while well meaning, isn't right for everyone. Investors might hear that a Roth IRA will always be best, for example, or that you should go out of your way to house tax-inefficient investments inside of it.

With IRA-contribution season in full swing--you have until April 15 to make a contribution for the 2014 tax year--here are seven common myths about making a contribution to one of these tax-favored accounts.

Myth 1: If you contribute to an IRA, you won't be able to get your money out unless you have some type of extenuating situation--for example, you're buying a home or going back to school. Investors may have heard about complicated rules for IRA withdrawals--that they'll need to be buying a home or paying off big medical bills, for example, in order to get their money out without any taxes penalties prior to retirement. Traditional IRA withdrawals and withdrawals of investment earnings from Roth IRAs are indeed governed by some byzantine rules. But Roth contributions are always accessible at any time and for any reason without taxes or penalties. Ditto for the new myRA accounts, which are essentially Roth accounts for investors just starting out. That's not to say raiding an IRA is a good idea, but investors shouldn't delay contributions if they're concerned they may need to tap their accounts prematurely. (Such investors should just be sure to park at least some of their Roth IRAs in liquid assets in case they might need to pull their money out prior to retirement.)

Myth 2: A Roth IRA is always the best type. Many investors have heard so much about the tax-saving benefits and flexibility of Roth IRAs--tax-free withdrawals in retirement, no required minimum distributions, the ability to take tax- and penalty-free withdrawals of their contributions--that they don't even consider a Traditional IRA. And it's true that young investors--especially those who are just getting started in their careers--are usually better off contributing to a Roth, because it's a good bet they'll be in a higher tax bracket in retirement than when they're on a starting salary. Midcareer savers who have already accumulated substantial traditional 401(k) and IRA assets would also do well to consider Roth contributions. Even if they don't know how their current tax bracket will stack up relative to their in-retirement years, accumulating assets in both Traditional and Roth accounts is a good way to hedge their bets.

But late bloomers--those who haven't yet saved a lot for retirement--may, in fact, be better off making a Traditional IRA contribution, assuming they can deduct the contribution on their tax returns. (This article outlines the income limits.) That's because their small savings means they may, in fact, be in a lower tax bracket in retirement than they are now, so they're better off taking advantage of the tax break today. This article addresses some of the other reasons one may not want to reach for a Roth.

Myth 3: You can't make a Roth IRA contribution if you earn too much. High-income individuals may skim the income limitations for Roth IRAs and assume that a Roth IRA contribution is off limits. But those income limits are but a formality these days, given that there are no income limits on conversions from Traditional IRAs to Roths. (Prior to 2010, there were.) Thus, a high-income individual may get into a Roth IRA by opening a Traditional nondeductible IRA--on which there are no income limits--then converting shortly thereafter. The tax consequences should be minimal, assuming the investor doesn't accumulate a lot of investment earnings before the conversion and has no other Traditional IRA assets. This article details the backdoor IRA maneuver, as well as how those with big Traditional IRA balances can get into trouble with a backdoor Roth IRA.

Myth 4: You shouldn't fund a backdoor IRA if you have a lot of Traditional IRA assets. There's more than a kernel of truth here: Would-be Roth IRA investors going in through the backdoor can, in fact, trigger a larger-than-expected tax bill on their conversion if they have other Traditional IRA assets. But this isn't an intractable problem for all investors. For those who can also contribute to a good-quality company retirement plan--where that plan offers so-called "roll-ins" from other 401(k)s or IRAs--combining the pretax Traditional IRA assets with the 401(k), 403(b), or 457 can be a good workaround, as discussed here.

Myth 5: High-income investors can benefit from investing in--and hanging on to--a nondeductible IRA. Investors who earn too much to deduct a Traditional IRA contribution and are shut out of the backdoor Roth maneuver--because they have substantial Traditional IRA assets and lack a worthwhile company retirement plan to roll those monies into--might assume they should just contribute to a nondeductible Traditional IRA and let it ride. But that would be a mistake in most instances. After all, they can readily mimic the tax-sheltering features of a Traditional IRA within their taxable accounts, by holding exchange-traded funds, individual stocks, and municipal-bond funds, for example. Additionally, withdrawals from a taxable account are eligible for long-term capital gains treatment as low as 0%, whereas IRA withdrawals are subject to ordinary income tax. (Investors in nondeductible IRAs do, however, get to skirt taxes on their cost basis when they withdraw their assets.) Finally, investors in taxable accounts aren't subject to required minimum distributions, unlike Traditional IRA investors.

Myth 6: You can't contribute to an IRA once you hit age 70 1/2. It's true that you can't contribute to a Traditional IRA once you pass age 70 1/2; in fact, that's the year in which you're supposed to begin taking required minimum distributions from the account. But turning 70 1/2 is a non-event for Roth IRA owners, and contributors, too. As long as the individual (or his or her spouse) has enough earned income to cover the amount of that contribution--that is, income that comes from working and not Social Security, a pension, or an investment portfolio--it's possible to fund a Roth IRA at any age.

Myth 7: You should only hold tax-inefficient investments inside your IRA. Many investors have heard about the basic concept of asset location--basically, holding tax-inefficient assets like bonds and REITs within their IRAs and tax-friendly types, such as ETFs, index funds, individual stocks, and municipal bonds, within their taxable accounts. That's sound advice, but investors shouldn't go out of their way to invest their IRAs in tax-inefficient investments. For investors with very long time horizons for their IRAs, stocks are the way to go--never mind bonds. In a similar vein, indexing true believers should go ahead and populate their IRAs with index funds and ETFs; those vehicles also happen to be tax-efficient, but that attribute won't drag on their returns. (By contrast, munis will only make sense for taxable accounts, because a muni bond typically pays a lower yield in exchange for its tax benefits.)