20 IRA Mistakes to Avoid
From contributions to conversions to distributions, don't fall into these traps.
Editor's note: This content is part of Morningstar's Tax and IRA Guide special report. A version of this article appeared on March 10, 2016.
This article has been updated to reflect the new U.S. tax filing deadline of May 17, 2021.
For a vehicle with an annual contribution limit of just $6,000 ($7,000 for those over 50), investors sure have a lot riding on IRAs. Assets across all IRA accounts topped $11 trillion in 2020, according to data from the Investment Company Institute. In addition to direct annual contributions, much of the money in IRAs is there because it has been rolled over from company retirement plans of former employers.
Opening an IRA is a pretty straightforward matter: Pick a brokerage or mutual fund company, fill out some forms, and fund the account. Yet, there are plenty of ways investors can stub their toes along the way. They can make the wrong types of IRA contributions--Roth or Traditional--or select suboptimal of investments to put inside the tax-sheltered wrapper. And don't forget about the tax code, which delineates the ins and outs of withdrawals, required minimum distributions, conversions, and rollovers. (The SECURE Act, which was signed into law at the end of 2019, ushered in some changes related to IRAs, including the delay of required minimum distributions to age 72. The CARES Act, passed in 2020 in response to the pandemic, also had implications for IRA holders, including a pause on required minimum distributions.) Rules as byzantine as these provide investors with plenty of opportunities to make poor decisions that can end up costing them money.
Here are 20 mistakes that investors can make with IRAs, as well as some tips on how to avoid them.
1. Waiting Until the 11th Hour to Contribute
Investors have until their tax-filing deadline--May 17 in 2021--to make an IRA contribution if they want it to count for the year prior. Perhaps not surprisingly, many investors take it down to the wire, according to a study from Vanguard, squeaking in their contributions right before the deadline rather than investing when they're first eligible (Jan. 1 of the year before). Those last-minute IRA contributions have less time to compound--even if it's only 15 months at a time--and that can add up to some serious money over time. The year 2020 was a great example; investors who waited until early 2021 to make their contributions would have missed out on an 18% return from the S&P 500 and a nearly 8% gain on the Bloomberg Barclays Aggregate Index. Investors who don't have the full contribution amount at the start of the year are better off initiating an auto-investment plan with their IRAs, investing fixed installments per month until they hit the limit.
2. Assuming Roth Contributions Are Always Best
Investors have heard so much about the virtues of Roth IRAs--tax-free compounding and withdrawals, no mandatory withdrawals in retirement--that they might assume that funding a Roth instead of a Traditional IRA is always the right answer. It's not. For investors who can deduct their Traditional IRA contribution on their taxes--their income must fall below the limits--and who haven't yet saved much for retirement, a traditional deductible IRA may, in fact, be the better answer. That's because their in-retirement tax rate is apt to be lower than it is when they make the contribution, so the tax break is more valuable to them now.
3. Thinking of It as an Either/Or Decision
Deciding whether to contribute to a Roth or Traditional IRA depends on your tax bracket today versus where it will be in retirement. If you have no idea, it's reasonable to split the difference: Invest half of your contribution in a Traditional IRA (deductible now, taxable in retirement) and steer the other half to a Roth (aftertax dollars in, tax-free on the way out).
4. Making a Nondeductible IRA Contribution for the Long Haul
If you earn too much to contribute to a Roth IRA, you also earn too much to make a Traditional IRA contribution that's deductible on your tax return. The only option open to taxpayers at all income levels is a traditional nondeductible IRA. While investing in such an account and leaving it there might make sense in a few instances, investors subject themselves to two big drawbacks: required minimum distributions and ordinary income tax on withdrawals. The main virtue of a traditional nondeductible IRA, in my view, is as a conduit to a Roth IRA via the "backdoor Roth IRA maneuver." The investor simply makes a contribution to a nondeductible IRA and then converts those monies to a Roth shortly thereafter. (No income limits apply to conversions.)
5. Assuming a Backdoor Roth IRA Will Be Tax-Free
The backdoor Roth IRA should be a tax-free maneuver in many instances. After all, the investor has contributed money that has already been taxed, and if the money is converted shortly after contribution, those assets won't have generated much in the way of gains, either. For investors with substantial Traditional IRA assets that have never been taxed, however, the maneuver may, in fact, be partially--even mostly--taxable, thanks to something called "the pro rata rule."
6. Assuming a Backdoor Roth IRA Is Off-Limits Because of Substantial Traditional IRA Assets
Investors with substantial Traditional IRA assets that have never been taxed shouldn't automatically rule out the backdoor IRA idea, however. If they have the opportunity to roll their IRA into their employer's 401(k), they can effectively remove those 401(k) assets from the calculation used to determine whether their backdoor IRA is taxable. And even if getting into a Roth IRA via the backdoor may trigger some taxes after the conversion due to the pro rata rule, that doesn't necessarily negate the benefits of doing it.
7. Not Contributing Later in Life
Many Americans are working longer than they used to. In recognition of that fact, the SECURE Act removed the age limits on contributions to Traditional IRAs, and Roth IRA contributions were already allowable for people of any age. The key requirement is that the contributor or his/her spouse have enough earned income (from working, not from Social Security or their portfolios) to cover the amount of their contribution. Making Roth IRA contributions later in life can be particularly attractive for investors who don't expect to need the money in their own retirements but instead plan to pass it on to their heirs, who in turn will be able to take tax-free withdrawals. After all, Roth IRAs don't impose required minimum distributions. Traditional IRA contributionss will tend to be less attractive for older adults because they do have RMDs.
8. Forgetting About Spousal Contributions
Couples with a nonearning spouse may tend to short-shrift retirement planning for the one who's not earning a paycheck. That's a missed opportunity. As long as the earning spouse has enough earned income to cover the total amount contributed for the two of them, the couple can make IRA contributions for both individuals each calendar year. Maxing out both spouses' IRA contributions is, in fact, going to be preferable to maxing out contributions to the earning partner's company retirement plan if it's subpar.
9. Delaying Contributions Because of Short-Term Considerations
Investors--especially younger ones--might put off making IRA contributions, assuming they'll be tying their money up until retirement. Not necessarily. Roth IRA contributions are especially liquid and can be withdrawn at any time and for any reason without taxes or penalty, and investors may also withdraw the investment-earnings component of their IRA money without taxes and/or penalty under very specific circumstances. While it's not ideal to raid an IRA prematurely, doing so is better than not contributing in the first place.
10. Running Afoul of the Five-Year Rule
The ability to take tax-free withdrawals in retirement is the key advantage of having a Roth IRA. But even investors who are age 59 1/2 have to satisfy what's called the five-year rule, meaning that the assets must be in the Roth for at least five years before they begin withdrawing them. That's straightforward enough, but things get more complicated if your money is in a Roth because you converted Traditional IRA assets.
11. Thinking of an IRA As 'Mad Money'
Many investors begin saving in their 401(k)s and start to amass sizable sums there before they turn to an IRA. Thus, it might be tempting to think of the IRA as "mad money," suitable for investing in niche investments such an exchange-traded fund that is set up to capitalize on electric vehicles or cryptocurrency. Don't fall into that trap. While an IRA can indeed be a good way to capture asset classes that aren't offered in a company retirement plan, ongoing contributions to the account, plus investment appreciation, mean that an IRA can grow into a nice chunk of change over time. Thus, it makes sense to populate it with core investment types from the start, such as diversified stock, bond, and balanced funds, rather than dabbling in narrow investment types that don't add up to a cohesive whole. A good-quality target-date fund can be an excellent hands-off option for IRA assets.
12. Missing Out on the Chance to Fill Holes
For investors who have most of their assets in a company retirement plan, an IRA can be useful as a "completer" portfolio, filling in asset classes that are missing in the company retirement plan. While many 401(k) plans offer fine core stock and bond funds, they may be missing exposure to a few key areas. For example, Treasury Inflation Protected Securities are often missing in 401(k)s, but are a useful addition to retiree portfolios that include non-inflation-protected bond exposure.
13. Doubling Up on Tax Shelters
In addition to avoiding niche investments for an IRA, it also makes sense to avoid any investment type that offers tax-sheltering features itself. That's because you're usually paying some kind of a toll for those tax-saving features, but you don't need them because the money is inside of an IRA. Municipal bonds are the perfect example of what not to put in an IRA; their yields are usually lower than taxable bonds' because that income isn't subject to federal--and in some cases, state--income taxes. Master limited partnerships are also generally a good fit for a taxable account, not inside of an IRA.
14. Not Paying Enough Attention to Asset Location
Because an IRA gives you some form of a tax break, depending on whether you choose a Traditional or Roth IRA, it's valuable to make sure you're taking full advantage of it. Higher-yielding securities such as high-yield bonds and REITs, the income from which is taxed at investors' ordinary income tax rates, are a perfect fit for a Traditional IRA, in that those tax-deferred distributions take good advantage of what a Traditional IRA has to offer. Meanwhile, stocks, which have the best long-run appreciation potential, are a good fit for a Roth IRA, which offers tax-free withdrawals.
15. Triggering a Tax Bill on an IRA Rollover
A rollover from a 401(k) to an IRA--or from one IRA to another--isn't complicated, and it should be a tax-free event. However, it's possible to trigger a tax bill and an early withdrawal penalty if you take money out of the 401(k), with the intent to do a rollover, and the money doesn't make it into the new IRA within 60 days.
16. Not Being Strategic About Required Minimum Distributions
Required minimum distributions from Traditional IRAs, which now start post-age 72, are the bane of many affluent retirees' existences, triggering tax bills they'd rather not pay. But such investors can, at a minimum, take advantage of RMD season to get their portfolios back in line, selling highly appreciated shares to meet the RMDs and reducing their portfolios' risk levels at the same time.
17. Not Reinvesting Unneeded RMDs
In a related vein, retired investors might worry that those distributions will take them over their planned spending rate from their portfolios. (Required minimum distributions start well below 4% but escalate well above 6% for investors who are in their 80s.) The workaround? Reinvest in a Roth IRA if you have earned income or--more likely--in tax-efficient assets inside of a taxable account.
18. Not Taking Advantage of Qualified Charitable Distributions
RMD-subject investors also miss an opportunity if they make deductible charitable contributions rather than directing their RMDs (or a portion of them) directly to charity. That's because a qualified charitable distribution--telling your financial provider to send a portion of your RMD, up to $100,000, to the charity of your choice--reduces adjusted gross income, and that tends to have a more beneficial tax effect than taking the deduction. Note that there's a bit of a disconnect between the RMD and QCD ages. Qualified charitable distributions are available to people who are 70.5 or older, whereas RMDs don't start until age 72.
19. Not Paying Enough Attention to Beneficiary Designations
Beneficiary designations supersede expensive, carefully drawn-up estate plans, but many investors scratch them out with barely a thought or make them once but don't revisit them ever again. Be sure to keep your beneficiary designations up to date and be aware of the new(ish) rules related to RMDs for IRAs inherited by nonspouse beneficiaries.
20. Not Seeking Advice on an Inherited IRA
Inheriting an IRA can be a wonderful thing, but it's not as simple as it sounds. The inheritor will have different options for what to do with the assets depending on his or her relationship to the deceased and can inadvertently trigger a big tax bill by tapping the IRA assets without exploring all of the options. If you inherit IRA assets, get some advice from a financial or tax advisor before taking action.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.