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How to Avoid IRA 'Pain Points'

Small steps to avoid the 'procrastination penalty' can make a big difference in your eventual return.

Editor's note: A version of this article was originally published on April 18, 2019. It is part of Morningstar's Tax and IRA Guide special report.

Psychologists often talk about how we can improve our behaviors by eliminating the small frictions that get in the way of doing things that we know are good for us.

Working out is a great example. Doing it is challenge enough, so it's smart to eliminate even small barriers. To that end, wellness coaches recommend that you lay out your workout clothes the night before. That way, the prospect of fishing around for socks and T-shirts in a dark closet (while your spouse snoozes away) won't stand in the way of your exercise regimen.

In a similar vein, I've been reflecting on my own behavior with IRAs, and wondering if eliminating "frictions" could help me get more out of the IRA wrapper--and could help others do so, too. In most years, my husband and I have waited until tax season, in the following year, to make our contributions for the year prior. In other words, we've waited until the last minute, even when we had the cash at the ready in our taxable accounts and our contributions had nothing to do with our tax return. By making the contributions each April, we had delayed more than a full year beyond when we were first eligible to make those contributions.

For older investors and those who are contributing to lower-returning investment types, the opportunity cost of delayed contributions isn't that great. But research from Vanguard illustrates that the opportunity costs, both in terms of foregone returns and tax advantages, stack up when the contributions are delayed year after year. In that scenario, Vanguard's researchers conclude that a procrastinator could inadvertently dock her return by nearly $16,000 if she delayed her contributions each year over a 30-year period in which her portfolio returned 4%.

IRA contributors don't just procrastinate in funding their accounts. They also procrastinate in getting the money invested once it's in the account. Leaving the money in cash rather than steering it into a longer-term investment with higher return potential effectively exacerbates the opportunity cost of the late investment.

Removing the 'Pain Points' If either (or both) of those forms of procrastination ring a bell when it comes to your own IRA behavior, it's wise to think about how you can remove the roadblocks, or "pain points," that are contributing to it. That way, funding your IRA and getting the money invested can happen with minimal effort on your part. While older investors and/or those with more-conservative portfolios are apt to benefit less from these actions, younger investors will get more bang for their buck from enacting these changes.

IRA Pain Point 1: Contributions rushed in at the last minute.

Why it happens: Some IRA contributors are likely investing their tax refunds, which helps explain why they'd make their contributions each spring. Other IRA contributors may be waiting to see what their modified adjusted gross incomes are, as that's the figure that determines whether they can invest in a traditional deductible IRA, a Roth IRA, or must go the "backdoor" route (making a traditional nondeductible IRA contribution and then converting it). But for many of us, the delayed contributions amount to procrastination, plain and simple.

How to avoid it: Making contributions when you're first eligible--Jan. 1 of the tax year in question--is the best way to harness both investment compounding and the tax benefits of the IRA. But for many investors, coming up with $6,000 to invest ($7,000 if you're over 50) is a heavy lift. To help make IRA contributions more manageable, I like the idea of dollar-cost averaging into an IRA--contributing enough each month to hit the maximum allowable contribution, just as you might do with your 401(k). For investors under age 50, a $500 contribution per month will fully fund their IRAs; for those 50-plus, it's $583 per month. And don't let concerns about making the "right" IRA type (Roth or traditional) hold you up. While recharacterizing a Roth IRA to traditional (or vice versa) is no longer allowed following a conversion, you can still recharacterize an IRA contribution if you made the wrong type of contribution in the first place.

IRA Pain Point 2: Money remains in cash rather than being invested in long-term securities.

Why it happens: As with late contributions, it could be that some investors have a perfectly rational reason for leaving money in cash following their contributions. One of the key ones would be if someone making a last-minute contribution to a "backdoor" Roth IRA--funding a traditional nondeductible IRA with an eye toward converting the assets to Roth. In that instance, leaving the money in cash until after the conversion helps reduce the taxes due upon the conversion. That's because the taxes depend, in part, on any investment gains that rack up in the traditional account before conversion. With the money in cash, those gains are apt to be muted. For others, however, the delay may owe to choice overload, concern about equity-market valuations, or a combination of the two.

How to avoid it: If you're investing in a backdoor Roth IRA, leaving the money in cash until you've undertaken the conversion is reasonable. But for others, it's wise to craft a plan to invest your IRA contributions in long-term securities straightaway. One idea is to use a multi-asset fund, either a balanced fund or a target-date fund, as the default for new contributions. That helps ensure that those contributions start working for you from the get-go. Meanwhile, employing a multi-asset fund helps assuage worries about against putting contributions to work in a single asset class that could be expensive or overheated.

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