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Last-Minute IRA Contributors: 10 Mistakes to Avoid

Escape analysis paralysis when it comes to selecting the right IRA and getting the money invested.

Every year you resolve, "never again." And every year, you're rushing in an IRA contribution for the previous year at the eleventh hour, just before the mid-April deadline. (It's April 18 this year.) 

You're far from alone: Vanguard found that more than double the amount of contributions are made at the last moment as at the first opportunity.

Certainly, waiting until the last minute to make an IRA contribution is better than not making one at all. But Vanguard's study demonstrated that investors who wait until the last minute to contribute to their IRAs year in and year out hurt their long-term results because their assets have less time to grow in the market. Moreover, many IRA contributors rush in a contribution but leave the money to lie fallow in cash, Vanguard found

So, avoiding last-minute IRA contributions and getting that money invested as soon as possible are two traps to avoid. If you're rushing in a last-minute contribution, here are 10 more mistakes to step around. 

1) Making the wrong contribution type.
There are two main IRA types: traditional and Roth. And traditional IRA contributions are further subdivided into those that are deductible and those that are not. 

To help home in on the right IRA type, you need to consider two sets of questions. First, what type of IRA do you qualify for? And if you can make more than one type of IRA contribution, which of them is best? 

Answering the first question is fairly straightforward. If your 2015 modified adjusted gross income as a single filer is less than $116,000 ($183,000 for married couples filing jointly), you can make a full Roth IRA contribution. You can make a partial Roth IRA contribution if your income as a single filer is between $116,000 and $131,000; married couples filing jointly can make partial Roth IRA contributions for 2015 if their 2015 MAGI is between $183,000 and $193,000. 

Anyone can make a traditional IRA contribution, regardless of income. And those contributions can be deducted on your tax return, regardless of income, if you don't contribute to a retirement plan at work. Income limits apply, however, if you contribute to a company retirement plan and want to make a traditional IRA contribution that you can deduct on your tax return. In that instance, single filers' modified adjusted gross income must be below $61,000 for their 2015 contributions to be fully deductible; married couples filing jointly must have MAGI of $98,000 or less to make a fully deductible IRA contribution. (Those contributions are partially deductible for single filers earning between $61,000 and $71,000 and for married couples filing jointly with incomes between $98,000 and $118,000.) 

So, of those choices, what's the "right" one? For investors who earn too much to make either a Roth contribution or a traditional IRA contribution that's deductible, a nondeductible IRA is their only option. The tax advantages are limited, but such an account can be used as a conduit to a Roth IRA via "the backdoor," as discussed here

For investors who qualify for both a deductible traditional IRA contribution and a Roth, the answer boils down to when taking the tax break is more advantageous. Are you better off getting the tax break now, because your income is high relative to where it's likely to be when you're retired? If so, make a deductible IRA contribution and call it a day: You'll be able to deduct your contribution, though you'll pay taxes on your withdrawals. This is often a good strategy for people getting close to retirement who haven't yet saved much. If your taxable income is at a low ebb relative to where it will be in the future, the Roth will be the better bet: You're better off making a contribution of aftertax money in exchange for tax-free withdrawals in retirement. This is often a sound strategy for young earners who aren't earning much at the moment but whose careers are on an upward trajectory. 

2) Not splitting between contribution types if you're not sure.
Investors might throw up their hands after reading the above. How on earth are you supposed to know what your taxable income looks like now relative to what it will be in the future? If you're eligible to make either a traditional deductible IRA contribution or a Roth IRA contribution, there's a workaround: Divide your contributions between both account types in whatever proportion you like. Assuming you plan to contribute $5,500 to your IRA for 2015, you could steer $2,750 to a traditional IRA (an amount that you'll deduct on your tax return) and the other $2,750 to a Roth. This strategy can also make sense for investors who are "on the bubble"--who earn too much to make a fully deductible traditional IRA contribution but who can contribute to a Roth. 

3) Assuming IRA choice is irrevocable.
If you goof and choose the wrong IRA type, there's a workaround. The IRS allows what's called a recharacterization, essentially a do-over in the IRA. For example, if you funded a Roth IRA but later found out that you earned too much to make a contribution, you can recharacterize into a traditional IRA instead. It wouldn't be deductible because if you earn too much to contribute to a Roth, you automatically earn too much to make a deductible IRA contribution. This article delves into the details of recharacterizations, including the deadlines. 

4) Making a traditional nondeductible IRA contribution and leaving it be.
As noted above, individuals of any income level who are also contributing to a company retirement plan can make a traditional IRA contribution; they just can't deduct it on their tax returns. But whether you'd want to make such a contribution and leave it be is debatable: As this article discusses, the modest tax benefits of holding a traditional nondeductible IRA don't necessarily make up for the strictures it entails--notably, required minimum distributions post age 70 1/2. Instead, a better avenue for high-income folks shut out of the other IRA types is to use the nondeductible traditional IRA as a conduit to a Roth--that is, fund the traditional IRA, and then convert those assets to Roth later on. There are no income limits on conversions. This is called a "backdoor" Roth IRA. 

5) Executing a backdoor Roth with other taxable IRA assets in the picture.
But the backdoor Roth isn't for everyone. Specifically, investors who have other IRA assets that have never been taxed (they've been rolled over from an employer's 401(k) plan, for example) will find that a big share of their backdoor Roth IRA assets will be taxable due to the pro rata rule, discussed here

6) Not being deliberate about the backdoor conversion.
How long backdoor Roth IRA contributors should wait between funding the traditional IRA and doing the conversion has been the subject of some debate. And perhaps contributors feel an increased urgency to get the money over into a Roth these days, given the possibility that Congress could close the backdoor Roth IRA loophole. But as financial-planning guru Michael Kitces points out in this blog post, would-be backdoor Roth IRA contributors shouldn't move too quickly, lest they run afoul of what's called the step transaction doctrine. Kitces suggests waiting at least a year to convert the traditional IRA assets to Roth, whereas IRA expert Ed Slott has suggested a shorter time frame should work. Kitces also recommends in this video that rather than let the traditional IRA assets sit in cash until conversion (which has the salutary benefit of not producing a capital gain during that period), would-be backdoor Roth IRA contributors should actually get the traditional IRA assets invested, the better to demonstrate an intent to have a traditional IRA in the first place. 

7) Forgetting about spousal contributions.
For married couples with just one partner earning a salary, it's easy to get caught up in retirement planning for the earning spouse alone. But couples with the wherewithal to do so can make contributions on behalf of both partners, provided the earning partner has made enough to cover both contributions. 

8) Misunderstanding the rules about IRA contributions later in life.  
A septuagenarian once told me about his wily plan to reinvest his required minimum distributions from his IRA into a Roth IRA. (Roth IRA holders don't have to take RMDs.) That seems like a great idea; but remember, to make an IRA contribution, you or your spouse must have enough earned income--that is, not from your investments or Social Security--to cover the contribution amount.

But nor should seniors reflexively rule out Roth IRA contributions: If they can cobble together enough earned income via consulting or other part-time work, or their spouse is still working and has enough earned income to cover the contribution, they may be able to make at least a partial Roth contribution. (It's worth noting, though, that one of the big advantages of Roth IRAs--no required minimum distributions--is currently under scrutiny, as discussed here. If RMDs were required of Roth IRA holders, that would make Roth contributions later in life much less attractive.) 

9) Not using your IRA to address portfolio issues.
In contrast with 401(k)s, IRA investors have carte blanche on the investment front--with just a few notable exceptions. That can lead to analysis paralysis, and probably explains why so many newly arrived IRA investors hang out in cash for too long. One easy way to determine what to invest in is to take a look at your portfolio today, using Morningstar's X-ray functionality. How does your stock/bond/cash mix look relative to some reasonable target, whether Morningstar's Lifetime Allocation Indexes or a good target-date fund like those from the Vanguard or T. Rowe Price series? Does your portfolio skew heavily (and perhaps dangerously) toward a handful of sectors or a specific section of the Morningstar Style Box? You can use your contributions to an IRA to help correct any unintended bets. For example, adding a core bond fund can help a 55-year-old get closer to an age-appropriate investment mix, while adding a value ETF can help smooth out the risks in a growth-leaning portfolio. And because the contribution limits are fairly small, investors might also use their IRAs to express modest contrarian bets; when I funded my IRA this year, for example, I steered money to a foreign-stock fund that I know has ample exposure to unloved emerging markets. 

10) Not taking advantage of the IRA's tax-saving features.  
The sole benefit of investing inside of an IRA versus investing in a plain-old brokerage account is that you pick up tax benefits--tax-deferred compounding, at a minimum, plus a possible tax break on your contributions (traditional deductible IRA) or on your withdrawals (Roth). Thus, in addition to using your IRA to address portfolio issues or fill holes, it's a great idea to make sure you're taking maximum advantage of the tax breaks the IRA offers. All IRAs--regardless of type--provide an ideal way to shelter investments that kick off a lot of income and/or capital gains on a year-to-year basis (especially short-term gains). That makes them ideal receptacles for assets like high-yield bonds, REITs (whose dividends are taxed at ordinary income levels), and high-turnover equity funds. And because Roth IRAs allow tax-free withdrawals and are generally last in the distribution queue, they're the best holding pens for your highest-returning assets, especially stocks. 

Yet, even as you seek to take maximum advantage of the IRA's tax-saving features, you needn't actively seek out tax-inefficient investments that don't mesh with your plan. Young people should generally use their IRAs to hold stocks, even though stocks are more tax-efficient than bonds, and devotees of passive management shouldn't go out of their way to add investment types that aren't as tax-efficient as index funds.

Mark your calendars for the 2016 Morningstar Individual Investment Conference, taking place on April 2 at 9:00 a.m. CST. At this live-streamed event, we'll cover strategies to help you strengthen your investment plan, regardless of age or investing expertise. Register for free today.