10 Do's and Don'ts for Last-Minute IRA Contributions

Taxpayers are again getting a short extension to file their tax returns this year: Tax day is April 18 in 2017, owing to some vagaries of the calendar and holiday scheduling.

That means you have a few more days to pull together your tax return for the 2016 tax year (unless you file for an extension), as well as to make last-dash contributions to your IRA and health savings account.

If you're among the throngs sneaking in an IRA contribution here at the eleventh hour, here are some do's and don'ts to keep in mind.

Do Make the Right Type of Contribution Would-be IRA investors quickly hit a fork in the road: traditional or Roth? The right decision depends on your answers to two key questions.

First, what was your modified adjusted gross income for 2016? Income limits for traditional IRA contributions that you deduct on your tax return are the most stringent: For 2016, single filers need 2016 MAGI of less than $61,000 to make a fully deductible IRA contribution, assuming they can also contribute to a retirement plan at work, whereas joint filers need MAGI of less than $98,000 to make a full IRA contribution and deduct it on their tax returns. Roth IRA income limits are higher: Single taxpayers with modified adjusted gross incomes of less than $117,000 can make a full Roth IRA contribution, while married couples filing jointly with MAGIs of less than $184,000 can make a full Roth IRA contribution. Anyone, regardless of income, can make a traditional nondeductible IRA contribution, which can then be converted into a Roth IRA. (More on this in a moment.)

If you can contribute to either a traditional deductible or Roth IRA, the next question is whether you need the tax break more now, because your income is high relative to what it's apt to be in retirement, or later on, because your in-retirement income is apt to be higher than it is today. If you think you'll benefit more from the tax break now than later on, you're better off making a deductible traditional IRA contribution; you'll deduct it on your 2016 tax return, but you'll pay tax on withdrawals in retirement. If you think the tax break will be more beneficial later on, a Roth is mostly likely your answer: In exchange for contributing aftertax dollars, you'll be able to take the money out tax-free in retirement. Also consider the virtue of tax diversification, and take stock of your balances in all tax-sheltered vehicles, both IRAs as well as company retirement plans. If the bulk of your portfolio is stashed in traditional accounts that will be taxed upon withdrawal, consider steering your IRA contribution to Roth to improve your tax diversification.

Don't Be Deterred by Paralysis Over the Right IRA Type If you're not sure which IRA type to contribute to, remember that you have a valuable escape hatch if you make the wrong election initially. If you make a contribution type that in hindsight was ill-advised or not allowed--for example, you contribute to a Roth IRA but find out that you were ineligible to do so due to income limits--you have a valuable escape hatch. A recharacterization is a do-over for IRA investors, allowing you to convert your IRA from Roth to traditional and vice versa. (Most financial-services providers offer a "recharacterization kit" that will walk you through the steps you need to take.) Just remember to mind the deadlines for recharacterizations: For contributions made for the 2016 tax year, you'll need to recharacterize by Oct. 16, 2017. This article includes more details on IRA recharacterizations.

Do Multitask with a Roth IRA If you're torn between the competing financial goals of building out your emergency fund while also saving for retirement, a Roth IRA can provide an ideal way to split the difference. That's because you can withdraw your Roth IRA contributions at any time and for any reason without paying taxes or a penalty. Ideally, you'd leave your Roth IRA assets undisturbed until retirement, but the ability to take withdrawals of your contributions without any repercussions makes it a highly versatile vehicle.

Don't Forget about the Five-Year Rule The contributions you've made to your Roth IRA have already been taxed, so there shouldn't be any tax consequences for pulling the money out prematurely. But if you want to take a tax- and penalty-free withdrawal of the portion of a Roth that consists of investment earnings (that is, the amount above and beyond your initial contribution), you need to be age 59 1/2, disabled, or using the money to pay for a first-time home. (Alternatively, your heirs can take tax- and penalty-free withdrawals after you've died.) In addition, you'll need to meet what's called the five-year rule, meaning that the assets must have been in the Roth for at least five years before you began withdrawing them. That sounds simple enough, but the five-year rule is complicated, especially if you've gotten money into the Roth IRA via conversions. This article does a deeper dive into the arcane five-year rule.

Do Consider Sneaking in Through the Back Door Roth IRAs have much to offer: In addition to tax- and penalty-free withdrawals of contributions, discussed above, qualified withdrawals of the whole Roth IRA account balance will be tax-free in retirement. Nor are Roth IRA accounts subject to required minimum distributions, unlike traditional IRA assets, making them ideal assets to earmark for heirs. One hitch, however, is that the higher-income investors who might have the most to gain from making Roth IRA contributions may be shut out due to income limits.

There's a workaround, however--the backdoor Roth IRA contribution. Under this maneuver, a high-income investor makes a traditional IRA contribution; the contribution can't be deducted, because if an investor earns too much to make a direct Roth IRA contribution, she automatically earns too much to make a deductible IRA contribution. After waiting a period of time, she can then convert those traditional IRA assets to Roth, because there are no income limits on conversions. (How long to wait is the subject of some debate in the financial planning community, as discussed here.) Assuming the investor doesn't have any other traditional IRA assets (more on this below), the conversion shouldn't trigger much, if any, taxes. To help ensure that the conversion doesn't incur more taxes than it should, be sure to file form 8606 in the year in which you made the contribution to the traditional IRA.

Don't Forget to Check Other IRA Assets First As effective as the backdoor Roth IRA maneuver is, it's not advisable for investors who already have traditional IRA assets. That's because the taxes due upon the conversion depend on the ratio between the investor's already-been-taxed assets (nondeductible contributions) and never-been-taxed assets (deductible contributions, investment gains). If an investor has a sizable balance in an IRA rolled over from a former employer's traditional IRA, for example, that's apt to dwarf the new traditional IRA contribution, meaning that a conversion of the new account would be primarily taxable. This article details how this works, and shares some examples.

Do Contribute, Even If You Can't Max Out You hear a lot about the limits for IRA contributions--$5,500 for people under age 50 and $6,500 for people 65 and older. But if you don't have the wherewithal to make a full contribution for 2016 in the next couple of days, don't let that deter you from making at least some type of contribution before tax day. Charles Schwab has emerged as the very small investor's best friend, offering ultralow-cost index funds with no minimum initial investment hurdles. Alternatively, investors buying on commission-free ETF platforms can get started by investing as little as one share. (Just be sure to read the fine print to insure that account-maintenance fees don't apply.) Consider dollar-cost-averaging into in IRA in the years ahead so you're not stuck scrambling to find the full contribution amount at the last minute.

Don't Ignore Catch-Up Contributions As with company retirement plans, people over age 50 are able to make additional "catch-up" contributions, to further plump up their accounts before retirement. For IRAs, investors over 50 can contribute an additional $1,000 per year, for a total contribution of $6,500. That might sound small, but contributing an additional $1,000 per year between the ages of 50 and 65, and earning a doable 5% return, will pad your IRA by another $22,000. If you're turning age 50 in 2017, remember that you don't need to wait until your birthday to make the catch-up contribution; you can make your full contribution any time that year.

Do Use Your IRA to Fill in Gaps in Your Portfolio Not sure where to invest your new IRA contribution? The best starting point for that decision is to use Morningstar's Instant X-Ray tool to assess your portfolio's current asset allocation, then compare that breakdown to your asset-allocation blueprint. (If you don't have an asset allocation blueprint, this article can help light the way.) You can then use your new IRA contributions to correct any imbalances that you've identified. Right now, for example, portfolios that have been left untouched for the past several years are apt to be light on bonds, foreign stocks, or both. Your new IRA contribution may not be enough to correct any unwanted over/underweightings, but it will get you headed in the right direction. Morningstar's Medalist mutual funds feature the funds that Morningstar's analysts deem best of breed in every category.

Don't Stay Put in Cash Vanguard's analysis of IRA contributors' investing patterns indicates that some investors rush their contribution into an IRA account at the last minute, but then let the money sit in cash for awhile before getting it invested. That delay in getting the money invested can take a toll on returns, especially for younger investors. If you've rushed in your IRA contribution at the last minute but don't have time to make investment selections, one idea is to use an age-appropriate target-date fund, or perhaps a balanced or allocation fund, as the starting point. In so doing, you'll ensure that your money isn't laying fallow in cash even if stocks continue to ascend.