Benz's Top Tips for Contributing to an IRA

This presentation is an excerpt from our Premium-member webinar, Top Ideas for Your IRA.

Christine Benz: Now that those items are out of the way, let's take a look at our agenda for today. We are going to start by talking about the nitty gritty of IRA contributions. As many of you know, we are in IRA contribution season. You have until April 18 to make a contribution for the 2017 tax year, so I'll share some details about what you need to know before you make your contribution. Then, I'm going to spend some time talking about how to use Morningstar's resources and tools to help improve your IRA portfolio. Finally, in the bulk of today's presentation, we'll hear from some of Morningstar's top experts to get their best ideas for IRA contributions. Russ Kinnel will be joining us to share some actively managed fund picks. Ben Johnson will be here with some ETF ideas for IRA contributors. Sarah Bush is joining us with some fixed-income fund picks. Finally, Dan Rohr will be here to share some individual stock picks. We've got lots of concrete ideas if you are looking to fund an IRA or maybe make some improvements to your IRA portfolio.

In terms in what you need to know about making IRA contributions, a couple of key things: Contribution limits have been the same for a few years now. The contribution limit is $5,500 if you are under age 50; and $6,500 if you're 60-plus. That limit is the same regardless of whether you are contributing to a traditional or Roth IRA; it doesn't make a difference, the contribution limit is the same.

It's also important to note that if you can't swing a full contribution, so if you're looking at your budget and $5,500 or $6,500 seems out of reach for you, it's perfectly fine to make a lower contribution amount. The point is to get some money compounding on a tax-deferred or tax-free basis for your retirement, not so much how much you can contribute.

It's also worthwhile to note that age restrictions apply to traditional IRA contributions. It you're planning to make a traditional contribution, you must be age 70 1/2 or below. If you are contributing to a Roth IRA, the great thing is that age limits do not apply. You can continue to contribute past age 70 1/2.

It's also worth noting that income limits apply to both traditional deductible IRA contributions. If you want to make a contribution and deduct it on your tax return, you've got to come in below the IRS's income thresholds. There are also income limits that hold for Roth IRA contributions.

One thing that I wanted to mention though, before we leave this point about income limits, is that an idea that's available for people of all income levels is this idea of doing a backdoor, or sometimes called a two-step IRA.The basic idea is that you fund a traditional nondeductible IRA. There are no income limits, as long as you're not going to deduct that traditional IRA contribution on your tax return. Then shortly thereafter, you can convert that contribution to a Roth IRA. As of 2010, there are no income limits on doing those conversions either.

There are some important caveats to bear in mind if you're thinking about this maneuver, so if you're shut out of making a direct Roth IRA contribution, the main one is that if you have additional IRA assets beyond this smaller IRA that you're looking to fund via the backdoor, you can run into significant tax consequences at the time you make that conversion of that small, new IRA. This is an area, if you are someone who is shut out of a direct Roth IRA contribution, and by extension, you're shut out of making a traditional deductible contribution, get some tax advice before proceeding any further. But this backdoor maneuver is a handy maneuver to keep in mind for higher income folks.

Let's talk a little bit about the Roth versus traditional decision. If you have funded an IRA before, you know you hit that fork in the road where you have to decide do I want to make a traditional IRA contribution, or do I want to do a Roth contribution? The key thing to know is that the tax treatment is different. In the case of a traditional contribution, you may be able to make a deductible contribution. Your money will compound on a tax-deferred basis; but then when you pull the money out in retirement, that's when you'll owe taxes.

In the case of Roth IRAs, the tax treatment is really almost the opposite. You will put aftertax dollars into that IRA. The money will compound and grow on a tax-free basis, and you will be able to pull that money out on a tax-free basis, assuming that you've left the money in the accounts for five years after funding. It's really sort of the opposite tax treatment.

A couple of other points to make about Roth versus traditional: traditional IRAs carry required minimum distributions; Roth IRAs do not. Then, on another point I always like to make about Roth IRAs is that they give you a little bit more wiggle room if, for whatever reason, you need to get your money out prematurely. If you withdraw your Roth IRA contribution, not the investment earnings piece, but just the contribution; you're able to take that money out without any taxes or penalties or anything else at any time and for any reason. That's a valuable escape hatch. That's one reason I often tell young investors that a Roth IRA is a really simple, flexible idea if they want to jump start their savings. Even if it turns out that they need the money early and don't let it grow and compound for retirement, they still can pull their contributions out on a tax- and penalty-free basis.

Let's just talk quickly about how to decide if you are going to contribute to a Roth versus traditional account. The key thing to think about is what your tax bracket is today versus what you expect it to be in the future. If you think that your taxes are relatively high today and you can make a traditional IRA contribution and deduct it on your tax return, you're better off taking that tax break today, even if you have to pay taxes when you pull the money out in retirement. The reason that's better is because your tax bracket, you expect, will be lower in retirement. On the flip side, if you think that you're in a fairly low tax bracket today, and your taxes will go higher in the future; you're a good candidate for making a Roth contribution. You'd be able to pull the money out on a tax-free basis at that higher tax rate.

A lot of people, particularly young accumulators, might look at this and say, "I have no idea about my tax rate in the future relative to where it is today." In that case, assuming you can make both a traditional deductible contribution and a Roth IRA contribution, you might consider actually splitting your contributions across both account types. That's something that you can often do in the context of a 401(k) plan as well, where you're faced with that fork in the road, you can actually make both types of contributions.

Let's just quickly look at checking up on our IRA portfolio's allocations. If you are funding an IRA, I think a great starting point is to look at how your IRA portfolio is positioned today. Here I think Morningstar's X-ray tool can be such a great help. If you have a portfolio saved in our portfolio manager tool, you can x-ray it, and you'll see a screen that looks something like this that will show you your portfolio's asset allocation, and a lot of other data about your portfolio's positioning.

On my next screen, I just have a shot of our Instant X-ray tool. This is a quick and easy way to get your portfolio saved on Morningstar.com, if you don't already have one. If you have entered your portfolio, one of the key questions is, if I'm looking at this, how do I know if that asset allocation is on track? Well, on this slide, I have a couple of benchmarks that you can think about if you want to check up on the appropriateness of your portfolio's asset allocation. I always say a good target-date fund geared toward someone in your same age band is a great quick and dirty way to check up on your portfolio's asset allocation. I also often refer Morningstar.com readers to Morningstar's Lifetime Allocation indexes, which are a product of Morningstar Investment Management. We've got the link on this slide.

If you are a young accumulator, you certainly want to have appropriately high equity allocation; but if you're someone getting close to retirement, you want to think about making sure that you have enough in your portfolio in the safe stuff. That's cash for many of us, and that may be some bond exposure, some high-quality bond exposure in that portfolio.

Also check your portfolio's style positioning. If you haven't done so recently, as this bull market has worn on, we've seen many portfolios tilting toward the growth side of the style box, because growth stocks have generally out performed. That's something to check up on. You can also check up on your portfolio sector allocations relative to the S&P 500. That's not to say you need to be right on top of a broad market benchmark when looking at your portfolio, but it's a good starting point, just to make sure that you're not making any big inadvertent bets in your portfolio.

Also, check up on your individual holdings using Morningstar's tools and research. If you're a Premium Member, you have access to our analyst reports. You can see are star ratings for our individual equities. If you are fund investor, you can see our Medalist ratings for the mutual funds and the ETFs that you own in your portfolio. Do a checkup on what you have in your portfolio already. That might help you determine positions that you need to add or otherwise address in your portfolio.