6 IRA Mistakes to Avoid in 2023

Key Takeaways

• Why is it a mistake for people to rush to contribute to an IRA at the last minute?
• What people are sacrificing as a result of funding an IRA but delaying actually getting that money invested.
• Using the backdoor Roth IRA maneuver to get around income limits as long as investors have earned income of any kind.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. It’s IRA season, which is the period before tax day when people rush out to fund their IRAs. Joining me to discuss six IRA mistakes to avoid this year is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning.

Nice to see you, Christine.

Christine Benz: Good to see you too, Susan. Let’s delve into some of these mistakes. You say the first key mistake that people often make is rushing to contribute at the last minute to an IRA. Why is that an issue, and how can people avoid it?

Benz: Right. When investment providers look at when people make their contributions, they often do take it down to the wire. So, they rush in their IRA contribution, say, for 2022 right before the tax-filing deadline, which in 2023 is April 18. The reason you don’t want to do that is foregone compounding. It’s not a big deal if you do it one year. But if you do it year after year, that’s 12 months, maybe 15 months of foregone compounding. So, I think that ideally, you would get those contributions in as soon as you’re able to make them. You can make your 2023 contribution now as of Jan. 1. You could start funding that 2023 IRA. I like the idea of people doing that. Or maybe looking at a dollar-cost averaging plan where you’re putting regular sums in each month, because in a lot of households that total IRA contribution can be kind of a heavy lift. So, why not space it out to make it more manageable for yourself?

Dziubinski: Now the second mistake that a lot of us make is somewhat related, and it’s maybe you will fund the IRA but then you delay going in actually getting that money invested. Let’s talk about that and what people are sacrificing as a result of not getting those dollars invested more quickly than they often do.

Benz: Right. This is another insight from investment providers. Vanguard did some great research a few years ago, where they looked at what they called the procrastination penalty. They looked at this two-factor issue where people are late getting these contributions in, and sometimes they put the money in, but they don’t put the money in anything. It just sort of sits there in the cash account. I think a great way to work around that is, assuming these are funds that you are setting aside for your own retirement, why not use a target-date fund here as well? I think they’re arguably underutilized in the IRA context. Of course, people use them very much in 401(k) plans. But I think they’re equally effective, equally hands-off and easy to use in the years leading up to retirement as a target-date fund would be in a 401(k).

Dziubinski: Speaking of getting those IRA funds invested, one risk that you think some investors may face this year in particular is being too conservative with how they invest those IRA assets based on what we saw in the market last year. Let’s talk a little bit about that.

Benz: Right. I think there are two factors at play here. I’m hearing a lot of enthusiasm for very conservative investments, cash investments in part because stocks were bad last year, bonds were bad last year, but also yields are starting to look pretty compelling. You can earn a 4% FDIC-insured return on a savings account today or on some sort of CD or very safe account. The risk, though, I think if you’re a younger investor especially is that you are locking in a very low yield. You will not be participating in the equity market’s potential for gains. So, my thought is that for younger investors, conservative investments probably aren’t a great fit. They probably want to be more long-term-oriented. And we can all just fall into this trap of recency bias, where the very recent past affects what we do. If you’re a younger investor or even sort of an intermediate-term investor with 10 years to retirement, you probably don’t need extremely safe investments within your IRA.

Dziubinski: Another mistake sometimes investors will make is that they can’t make an IRA contribution because they earn too much money. So, how can investors get around income limits when it comes to IRAs?

Benz: Right. So, people will see their income limits if they want to make deductible traditional IRA contributions. There are higher income limits that apply to Roth contributions. If you look at those Roth contribution limits and say, “Well, I make more than that.” Don’t assume you’re shut out. You can take advantage of what’s called the backdoor Roth IRA maneuver. And the basic idea is that you fund a traditional nondeductible IRA. There aren’t any income limits on that type of IRA. You can fund it as long as you have earned income of any kind. You can earn a lot of earned income and still make that traditional nondeductible contribution. So, you fund that type of account. And then, shortly thereafter ideally, you convert it to a Roth account, and there aren’t any income limits on those conversions, either. So, it’s a great way to get funds into an IRA, even if you are a higher earner who can’t make that direct front-door IRA contribution.

Dziubinski: With the backdoor IRA contribution, though, if investors do have a lot of IRA assets in general, they have to be a little careful with that. Let’s talk about that.

Benz: Right. It’s such a good point, Susan. There’s what is called the pro rata rule that applies to all of your traditional IRAs. And if you’re doing conversions or you’re taking distributions from your IRAs, from your traditional IRAs, the IRS looks at the composition of those IRAs. So, if you’re just making that little nondeductible contribution and doing the conversion, if you don’t have any other IRA assets, that shouldn’t cost you much in taxes. If, on the other hand, you have a lot of assets in a traditional IRA that consist of deductible contributions, so funds that you’ve never paid taxes on, that could cause the conversion of your small new IRA to be at least somewhat taxable. So, do your homework on what the tax bill might be. It’s not a reason to necessarily avoid doing that backdoor maneuver but just understand that you may owe a little bit more in taxes than would be the case if you just had that single, nondeductible traditional IRA that you were converting and doing the backdoor maneuver with.

Dziubinski: Got it. The last mistake you think that investors sometimes make is that they reflectively choose the Roth IRA as the option and don’t really consider the traditional IRA. Why is that?

Benz: Right. Well, there’s a lot to like about Roth. You are able to take tax-free withdrawals in retirement. Who doesn’t like that? And then, there aren’t any required minimum distributions on Roth IRAs, either. So, two big advantages of having Roth IRAs. But the reason that some people should look at making a traditional deductible IRA contribution is if they’re in a relatively high tax bracket at the time of contribution relative to where they might be when they begin pulling the funds out in retirement. So, a great example would be kind of a late-career saver, earnings are fairly high, but that person hasn’t saved a lot for retirement. In that case, he or she might be better taking the tax break today at the higher tax level and then paying taxes on the funds in retirement upon withdrawal. So, run the numbers on that. It’s not automatic that Roth IRA is the right answer for everyone. And then, I would also say, we’ve been watching with Secure 2.0, which was a piece of legislation that passed at the end of last year, we’ve been watching the required minimum distribution limits, the age limits, on traditional IRAs go up and up and up, and they’re going to go up further in 2033, all the way to age 75. That, in a way, is taking away what had been one of the big knocks on traditional IRAs that you’re subject to these RMDs, and I think making it a little less of an issue for many households.

Dziubinski: Well, Christine, thank you for walking us through these mistakes today and hopefully, we won’t make them anymore because we’ve been listening to what you’ve just told us. Thank you for your time.

Benz: Thank so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “New Rules for IRA Distributions” for more from Christine Benz.