10 Myths About IRA Contributions

Editor's note: A version of this article was initially published on March 26, 2018. It is part of the 2020 Tax and IRA Guide.

Many investors have heard the admonitions about why they should contribute to an IRA as soon as they possibly can: for the 2019 tax year, that would have been Jan. 1, 2019. And yet many investors wait until the last minute--their tax filing deadlines--to make a contribution for the year prior. Vanguard's data has shown that more than twice as many IRA contributions come in in April of the year following the tax year than in January of the current year. Within the next few months, investors will be rushing in their contributions for 2019, even though they could have done so more than a year earlier.

Of course, some investors might be waiting to see their tax pictures to make a contribution. That's not unreasonable, as an investor's ability to contribute to a Roth or make a traditional deductible IRA contribution depends on the taxpayer's modified adjusted gross income, which isn't knowable until the tax return is complete. For a lot of other investors, however, delayed IRA contributions are the result of human nature; inertia is a powerful force, and it's always hard to find the money for the delayed gratification that is retirement savings.

And thanks to the tax code, there's an unhealthy amount of confusion surrounding the various silos that can be used for retirement savings. With Roth and traditional IRA contributions come a bewildering array of rules about tax treatment and income limits. For many, analysis paralysis is no doubt a part of IRA procrastination, too.

Here are 10 common points of confusion--or myths--about IRA contributions.

1. You can't contribute after a certain age. While traditional IRA contributions were previously unavailable to investors over age 70-1/2, Congress changed that by passing the SECURE Act in late 2019. Among other changes to the retirement regulations, the Act dropped income limits for traditional IRA contributions, bringing them in line with Roth IRA contributions. (In most situations, Roth IRA contributions will still tend to make more sense than traditional.) The key caveat for contributions later in life is that the contributor must have enough earned income (not income from Social Security, a pension, or their portfolios) to cover the amount of the contribution.

2. You can't contribute if you don't have earned income. This is true if you're a single taxpayer. But if you're part of a married couple filing jointly and your spouse has enough earned income to cover the amount of your contribution, you can make an IRA contribution in your name, too. The so-called spousal IRA is a valuable retirement-savings tool for couples with a nonearning spouse--for example, a partner whose day job is parenting, or a spouse who has retired even as his partner continues to earn a paycheck. Note that you won't find a "spousal IRA" form on your investment provider's website; if you're the spouse without earned income, you would simply contribute to a Roth or traditional IRA.

3. Children can't make IRA contributions. This is true if your child doesn't have any earned income in his or her name. But if your child or grandchild has a job that generated earned income, he or she can make an IRA contribution. One important point is that the actual dollars used to contribute to the account don't have to come from your child's coffers. Say, for example, that your son was a lifeguard last summer, but the money he earned is long gone. Because he had earned income, you can make a contribution on his behalf. A contribution of just $2,000--without additional contributions but left to grow at a 6% rate of return--would add up to more than $38,000 50 years later!

4. You can't make a contribution if you earn too much. Contributions to IRAs carry income limits. But anyone with earned income can make a traditional IRA contribution; you just won't be able to deduct it on your tax return if your modified adjusted gross income exceeds the thresholds. The sole benefit to making a nondeductible IRA contribution and leaving the money in that wrapper is that you'll enjoy tax-deferred compounding on your money. But things get more interesting if you then convert that traditional IRA to a Roth, as doing so enables you to take tax-free withdrawals on your money. This is called a "backdoor Roth IRA."

5. Backdoor Roth IRA contributions will always be tax-free. Getting into a Roth IRA via the backdoor--making a traditional IRA contribution and then converting it to a Roth account--should be tax-free or mostly tax-free in many situations. A key caveat is if you have additional IRA assets that you've never paid taxes on--say, a rollover IRA from a former employer. In that case the IRS' pro rata rule comes into play, meaning that the taxes on your conversion depend on your whole IRA pool, not just your new, smaller IRA. If the bulk of your IRA assets has never been taxed, your conversion will be mostly taxable, too.

6. A backdoor Roth IRA is off limits if you have other IRA assets. We're a nation of job-hoppers, so many of us have pools of never-been-taxed IRA assets, such as rollover IRAs. That makes it crucial to think twice before undertaking a backdoor Roth IRA, as much of the converted amount is going to be taxable. That said, there's a workaround for people in this situation. If you're contributing to a company retirement plan that allows "roll-ins," you could transfer your rollover IRA assets (the monies that have never been taxed) into your company plan. The net effect of that is that the pro rata rule is no longer a problem for you (it applies to IRA assets, not 401(k)s and the like). You can then happily conduct the backdoor Roth IRA maneuver without the threat of a big tax bill. Of course, you'll want to make sure your 401(k) is a good-quality plan before rolling your IRA assets into it.

7. A nondeductible IRA contribution is a good investment in its own right. So what if you earn too much to make a direct traditional or Roth contribution, and the backdoor maneuver isn't advisable because you have other traditional IRA assets that can't be rolled into a company retirement plan? Should you just make a traditional nondeductible IRA contribution anyway? Experts vary on this topic, but I have a hard time seeing their point. Yes, the traditional IRA affords you tax-deferred compounding. But that tax benefit comes with significant strings attached--you won't be able to get your money out prior to retirement without taxes and/or penalties, and you'll be required to take minimum distributions from that account once you pass age 72.

By contrast, if you forego the traditional nondeductible IRA contribution and simply invest in a plain-vanilla taxable brokerage account, you'll have a lot more flexibility on withdrawals. You may also come out ahead on the tax front: Not only can you invest the taxable assets in an extremely tax-efficient way, limiting income and capital gains distributions during your holding period, but when you pull the money out in retirement, you'll owe taxes on your gains at your (lower) capital gains rate, versus the ordinary income tax rate that applies to withdrawals of IRA assets that have never been taxed. (In the case of withdrawals from a traditional nondeductible IRA, you'd be taxed upon any investment appreciation in your account rather than on your contributions.)

8. If you make the wrong type of IRA contribution, you're stuck. Prior to 2018, you could essentially "undo" a conversion from traditional IRA to Roth (or vice versa) but that maneuver, called a recharacterization, is no longer allowed. But you can still undo a contribution to the wrong account type. Let's say you made a contribution to a Roth IRA before you realized that your income was over the limits and your only option was to make a traditional (nondeductible) IRA contribution. You're still allowed to recharacterize your contribution.

9. Roth IRA contributions are always the best. Roth IRAs enable you to take tax-free withdrawals in retirement, provided you're 59 1/2 and your assets have been in the account for at least five years. By contrast, traditional IRA assets are taxable upon withdrawal. And in general, you'll have more flexibility with a Roth IRA: You can withdraw your contributions at any time and for any reason and you won't be subject to required minimum distributions, unlike traditional IRA assets.

So, advantage Roth all the way, right? Not necessarily. The key factor to keep in mind when deciding between a Roth and traditional account is your tax rate at the time of your contribution versus your tax rate in retirement. If you think your taxes will go lower in retirement--for example, you're getting close but you haven't yet saved a lot, meaning your income and tax rate are apt to go down--you may well be better off making a traditional IRA contribution and taking the deduction today versus taking the tax break later on, when it's worth less to you.

10. You should use your IRA contribution to invest in areas that aren't represented in your company retirement plan. The previous myths all relate to IRA mechanics. But how about investing your IRA dollars? One of the biggest myths I hear repeated is that you should use your IRA assets to fill in spots that aren't represented in your 401(k) or other company retirement plan--say, real estate investment trusts, junk bonds, or emerging-markets equities. That's decent advice for people who already have a large pool of money set aside in a 401(k), with ample exposure to the major asset classes--U.S. and foreign stocks and high-quality bonds. But for investors who are just starting out, their IRA purchases should be similarly focused on core-type investments; there's no need to dabble in the niche asset classes before building critical mass in the core building blocks.

Likewise, investors are sometimes urged to focus their IRA assets on tax-inefficient assets, the better to take advantage of the tax benefits that IRAs afford. But if your favorite investment type happens to be tax-efficient--and equity index funds and exchange-traded funds are a great example of that--there's no reason to go out of your way to avoid them in your 401(k).