IRA Contribution Tips and Traps

Investors have until April 15 to make an IRA contribution for the 2014 tax year. In a recent interview with Morningstar director of personal finance Christine Benz, retirement expert and author Ed Slott shared some tips to explore and traps to avoid during IRA contribution season. In this excerpt, Slott discusses the key differences between Roth and Traditional IRA contributions, the pitfalls of backdoor Roth conversions, and the importance of spousal contributions and beneficiary forms.

Christine Benz: Let's begin by talking about some of the key mistakes people make when they're putting money into their IRAs. One of the key decisions people are confronted with is whether to do Roth or Traditional IRA. Do people tend to get tripped up by that decision?

Ed Slott: When it comes to contributions, people probably don't understand that there is a big difference. I happen to like the Roth; you don't get a tax deduction, but the money goes in and when the money comes out, it's all tax-free. In effect, you pay going in because you don't get a deduction. But then it grows tax-free for the rest of your life. And the thing I like about Roths: There are no lifetime required minimum distributions. Even at 70 1/2, if you don't need the money, it still grows. And it grows in the best account you could have: a tax-free account, never eroded by taxes. It's pure growth for the rest of your life.

Benz: Even though you generally prefer the Roth IRA in most situations, are there any situations where doing that Traditional IRA, taking the tax deduction upfront, is the better idea?

Slott: I guess there are some situations. People say if you are in a high tax bracket, you get a tax deduction; but it's not that much of a deduction. Remember, on the contribution side, you are limited to $5,500 a year for 2015; $6,500 if you are 50 or over. So, the most we're talking about is a tax deduction on even the $6,500. I would give that up because if you take the deduction, yes, you save some money in the short-term right now, but then you pay for it for the rest of your life because all of the earnings from that point on are a tax waiting to happen. I don't think it's worth it for most people.

Benz: One assumption that people might make when they look at the income limits that govern IRA contributions would be, "Well, if I'm a high-income earner, I can't make any IRA contribution at all." That's a myth, though.

Slott: There is no income limit, believe it or not. I know everybody says that, just like you said. But there is no income limit for contributing to an IRA. You could make $1 billion and still be able to contribute to a Traditional IRA--not a Roth. We are talking about a Traditional IRA. The only time an income limit comes in is if you are already covered by a plan at work. If you're covered by a plan at work or your spouse is, then there are certain income limits. But it still doesn't mean you can't have an IRA; it just means you may not be able to deduct the contribution.

Benz: Let's say I open a Traditional nondeductible IRA. I could stay in that Traditional nondeductible IRA, or I could do a conversion to a Roth IRA. Given that you like Roths, you probably think converting is a good idea.

Slott: That's become known as the "backdoor" conversion because, with Roths, there are income limits. They are high, but if you're a high-income earner, you might not be able to do a Roth contribution. But with Roth conversions, there are no income limits. A lot of people don't know that either, because there were limits years ago; if your income was over $100,000, you couldn't convert. But those rules were repealed in 2010.

Let's say you want to do a Roth but your income is too high. With this backdoor conversion, you can contribute to a Traditional nondeductible IRA and then convert that to a Roth--but that conversion may not always be tax-free. It's only tax-free if you don't have any other Traditional IRAs, SEP, or simple IRAs. If you have other IRA balances, then you have to figure those balances in and it's a percentage. So, even if you did save $5,500 as a nondeductible IRA contribution and converted that, it could be the case that if you have hundreds of thousands more in IRAs, only maybe 5% of that would be tax-free. It's called the pro-rata rule.

Benz: So, you could inadvertently clobber yourself with a high tax bill on that little conversion just because you have these other IRAs.

Slott: But if you have no other IRAs, that's a great scenario. There have been questions on whether you could really do that. And it was a gray area because the IRS never came out with anything. But I think we got the answer secondhand almost when the president released his budget recently. One of the provisions--and this is not the rule, this is the wish list--but one of the provisions was not to allow backdoor conversions any longer. By the administration wanting to close this loophole, they are probably saying it was OK to do in the past.

Benz: And that it is still OK for now.

Slott: It's like a tacit endorsement, saying it must be OK because now we are saying you can't do that. But that isn't the rule now--it's just a proposal.

Benz: Another thing that can trip people up when making contributions is they might assume that they're too old to make any sort of IRA contribution. Let's talk about that, because age limits do come into play.

Slott: IRAs do have age limits. Starting in the year you turn 70 1/2, you can no longer contribute to a Traditional IRA, but you can contribute to a Roth.

Benz: You've said that one of the most frequent mistakes people make when looking at IRA contributions is that they miss the spousal contribution. Let's talk about that--how that non-earning spouse can actually make a contribution.

Slott: I think most people miss it. Obviously, this is married couples where you have one spouse, the breadwinner, and the other spouse has little or no earnings. Let's use the 2015 numbers and assume the couple is under 50. Each could contribute $5,500. That's $11,000 total. As long as one spouse has made at least that much, he or she can contribute for himself or herself and the non-earning spouse. Most people forget that. There's a spousal version of a Roth, too, and that would be a shame not being able to put, say, another $5,500 or $6,500 in a Roth, because all you're doing with the Roth is moving it from one pocket to another. And this other pocket, the Roth, is tax-free. So, why wouldn't you do that all day long? I think a lot of people just don't think about it.

Benz: Another area where people can sometimes make a mistake is when they fill out that beneficiary-designation part. What are the potential errors that can arise there?

Slott: The number one item there--and this is probably the biggest mistake people make--is not filling out a beneficiary form properly. As a matter of fact, I'll tell you a story: I went with my brother years ago when he left his job, and he had an old 401(k). It sounds like the commercial you see on TV. He had an old 401(k), and he just wanted to roll it to an IRA. That was his decision. So, I went down with him to some fund company. It sounds like a simple thing. We go to see the representative there, and it's an easy rollover. And then he says to my brother, "Do you want to name a beneficiary at this time?" That's when I cut in and said, "Well, why wouldn't he? Why shouldn't everybody?" He says, "Some people don't like to do it." The way they present it, it's almost like, "Do you want this add-on?" Like when you buy a car: "Do you want these extras?" This is not an extra.

Benz: It doesn't cost anything.

Slott: Right. He made it sound like, "Do you want to add this?" And my brother said no. I said, "Yes, you want to have a beneficiary form." Not only that, you want to make sure it's correct. You want to keep a copy. You also want to make sure you have a contingent beneficiary in addition to your primary beneficiary. The contingent beneficiary is the key to the post-death planning, because let's say you die and, after death, somebody wants to disclaim or change beneficiaries, the contingent beneficiary is key.

So, I would say to everybody, as soon as you open an IRA, make sure you have a beneficiary named, a contingent beneficiary, and that they are the right people. Naming a beneficiary in your will--a lot of people think that they do estate planning, they go to a lawyer, and they think it's covered in the will. It could be, but that would be a mistake. The beneficiary form trumps the will.

I'll give you another tip, too. When people do a Roth conversion--let's say they didn't have a Roth before and they are converting an IRA to a Roth--that's a new account and it also needs a beneficiary form. It doesn't carry over from the IRA like osmosis. Then, even if you do all of that right, it means nothing if your family can't find that beneficiary form after you die. So, you would have to leave instructions to let them know where that copy is, because you can't rely on the financial institution to have it many years later. A lot of the banks over the years have merged, and nobody can find anything.

Benz: So, the lesson is to keep your documents current based on your life situation and also keep a record.

Slott: I even have some people do it on colored paper--neon colors. And each year, we update it so we know that a certain color is the current year.