How IRA Investors Can Avoid the ‘Procrastination Penalty’

Key Takeaways

• We are still seeing procrastinators making contributions toward the April 15 filing deadline. About 35% of contributions are coming in at the back end, and about 15% of those actually are at the April time frame.
• The “procrastination penalty” that occurs after repeatedly waiting until the very last minute to contribute to an IRA can translate into some significant lost opportunities for compounding.
• Choosing between a traditional or Roth IRA is not an either/or decision for many, it’s both; this is where the benefit of tax diversification comes into play.

Christine Benz: Hi. I’m Christine Benz from Morningstar. Some investors rush in their IRA contributions right before the deadline, but that’s not necessarily the right course of action. Joining me to discuss some healthy habits for IRA investing is Maria Bruno. She’s head of U.S. wealth planning research for Vanguard.

Maria, thank you so much for being here.

Maria Bruno: Hi, Christine. Good to be here. Thank you.

IRA Account Contribution Trends

Benz: So, let’s talk about this issue of investors waiting until the eleventh hour to make their IRA contributions, getting them in right before the tax-filing deadline. You and I have discussed in the past, Maria, that this is kind of a phenomenon that you see. Is this something that you’re continuing to see this year, for example?

Bruno: We do, Christine, but we’re seeing some really encouraging trends. Again, we’re looking at the 2021 tax year. And what we’re seeing is that more contributions are coming in early in the tax-filing year. So, we’re seeing actually about 20% of contributions come in as early as January, and that’s very encouraging. If we look through to April of that year, it’s about an additional 20% making contributions early. So, that’s quite encouraging.

That said, we are still seeing an incidence of procrastinators, people who are making that contribution toward that April 15 filing deadline. About 35% of contributions are coming in at the back end, and about 15% of those actually are at the April time frame. So, we still have more work to do there, but the trends are highly encouraging.

A couple of other things we’re seeing is that we’re seeing a higher adoption of Roth coming in in that early time frame. So, it seems like Roth contributors are the early-bird contributors, if you will, taking advantage of that tax-free compounding clock. And then, we’re also seeing a higher incidence of investors who are doing multiple contributions throughout that period whether it’s through automatic exchanges or manual contributions.

Benefits of Spacing Out IRA Account Contributions

Benz: You referenced that you’re seeing more people spacing out their contributions throughout the year. It seems like that’s a good development. Is there anything that Vanguard tries to do to encourage that behavior?

Bruno: Christine, the education, first and foremost, is very important for us. The more we can talk about and educate investors around the benefit of investing for retirement early, we take every opportunity to do that. But we also did a few interesting initiatives last year with some really good results. So, for instance, for the 2021 tax season, we tested out a new IRA dashboard during the enrollment process and then also some educational programs, basically just reminding clients to contribute to their IRAs before they lose that opportunity.

And the results were quite interesting and encouraging in that what we found was that clients who received these personal outreaches were actually 17% more likely to contribute. And of these clients that actually did these contributions, we saw a total of about $155 million added to their retirement savings. So, it’s quite exciting and encouraging that we’re actually able to help these investors improve their financial situation.

Another thing that we’re doing right now—granted we’re still in the middle of tax season—but we’re doing more personalized and frequent reminders to investors to take advantage of these retirement savings options. And what we’re seeing is those first-time contributors with Vanguard are actually not only making contributions but making contributions that are 15% higher than those who did not get these personal outreaches. So, what we’re really focusing on here is using data-driven insights to drive better investor outcomes. And the more we can do that, I think the more we can set clients up for investment success, much like our mission and principles employ.

What Is the Procrastination Penalty?

Benz: I wanted to follow up on those stragglers, the people who are rushing in their contributions right before the deadline. Can you talk about the penalty that someone incurs if they’re waiting year after year until the very last minute? At first blush, it doesn’t seem like it should be a big deal. But can you talk about how that can translate into some significant compounding, lost opportunities for compounding over time?

Bruno: I mean, we all realize the sooner you can start the compounding clock, the better, right? But there is—and we’re calling this the procrastination penalty—there’s a cost to waiting, and it doesn’t seem like a big deal when you think about it. But let’s look at a simple example. Let’s assume that we’re looking at someone who’s making their annual IRA contributions, that is $6,500 a year. Let’s say they’re hypothetically investing in a balanced fund, maybe earning a 4% real return. Over 20 years—and again, we’re looking at today’s dollars—over 20 years, that amounts to about a $10,000 difference. Over 30 years, it’s about $18,000. And that’s striking when you’re simply talking about the timing difference, whether you’re making a contribution in January or if you’re making a contribution 15 months later.

Now, this is a very generalized example. I realize that. But even the research that we’ve done that shows the power of early and lump-sum-type investing in capital markets forecasting just shows the value of compounding early. Now, I realize not everyone has the means to be able to make that contribution in January. But even if you were to set this up automatically and break that $6,500 down over that 15-month period, you’re looking at a $400 contribution monthly. So, if you can’t do it all at once, just having that discipline to be able to do it throughout that period is a very good, disciplined way to do that.

Benz: Right. Makes it much more manageable. I wanted to talk about a related issue here, and this is another thing that you flagged in the past is this issue of people get their contribution in, but then they let it sit in cash or something without a lot of earnings potential because maybe they’re not sure where to invest. Can you talk about that dimension of it and what Vanguard sees in terms of what participants do once they get the contribution into the account?

Bruno: This is a good one. And we do see procrastinators who tend to park that money in cash, they tend to be focused more on the act of making that contribution, maybe it’s a check-the-box exercise. And what they’re doing is decoupling that contribution and investment decision. And while many have the best intention to go back and invest that money, they don’t. And we find that it actually sits in cash for months. And there’s a big opportunity cost to remaining uninvested.

Now, it would be great. If you look at plan sponsors’ design and how plan sponsors can default individuals into a target-date fund or a balanced fund, that is a great behavioral tool. But we can’t do that directly with direct investors, but we should, and we should be able to help them avoid some of these pitfalls. And that’s very important for us at Vanguard, and I think there’s a lot that we can do in terms of not only educating our clients but making that online experience, that enrollment process, much more intuitive so that they can actually easily make that contribution and that investment decision all at once. That’s the key to make it easy and intuitive for investors.

Benz: Just to get it done in one fell swoop. And like you, I think that target-date fund is a great idea for an IRA, for people who aren’t sure where to put the money, but they know it’s for their retirement, it seems like a really solid option.

Bruno: Right. Absolutely. And just talking about and educating and personalizing that online experience can really go a long way, I think, in educating investors to do that. And then, they don’t have to go back and do it again. They’re well invested; they’re diversified, low-cost options. It’s a great start.

Roth IRA vs. Traditional

Benz: One fork in the road for IRA contributors is that they have to choose: am I making Roth or traditional IRA contributions? Of course, there’s a lot in the mix there, including income limits. But can you talk through what people should be thinking about when they’re trying to decide should they do Roth or traditional?

Bruno: Not an either/or decision for many, it’s both, and this is where the benefit of tax diversification comes into play, by holding the different account types. There are clear benefits to Roth for a lot of investors and that being the tax-rate growth, the ability to access the contributions income tax-free and penalty-free and also no lifetime RMDs. When we look at some of the trends that we’re seeing here at Vanguard, we are seeing more investors embrace Roth either directly or indirectly. If we look at age, for instance, we are seeing younger investors embrace Roth IRAs. Direct contributions, about 85% are going into Roths. If we consider backdoor Roths, it’s about 95%. So, clearly, the winner there is Roth, which is encouraging. It’s a good news story for young investors.

What’s also interesting though, we are seeing older investors, like the Gen X or the late boomers, also embracing Roth. About more than half of the contributions are going into Roth. And I thought this was interesting and also a good news story. Many of us have wealth built up in tax-deferred accounts, traditional accounts, 401(k)s, for instance. And we may not have the tax diversification. You’re either doing deferrals into 401(k)s, or Roth IRAs can provide some of that tax diversification, which gives more flexibility down the line. So, that’s quite encouraging as well.

Benz: Now, you referenced, Maria, those people who are perhaps later in their careers and considerations for them. I’m wondering if you can touch on IRA contributions for people at that life stage. What they should know about—and I know it’s a big topic—but the five-year rule that relates to IRA contributions. What should people who are making those late career contributions be keeping in mind?

Bruno: I think there’s two things. One is, Christine, where you are from an income tax standpoint. Because many who are close to retirement are in their peak earning years. So, from a tax standpoint, it may not be as clear-cut in terms of whether a Roth or a traditional. Another consideration is the holding period. So, we talked about being able to access the contributions. That’s always an option. But there’s a five-year holding period for earnings. So, for instance, there are no income taxes or penalties if you held the account for more than five years and you’re over 59.5. So, if you intend to tap those monies early, you might want to be mindful about that. And then, also with traditional 401(k)s, generally speaking, if you’re to tap that money before age 59.5, there are taxes and penalties as well. So, some considerations in terms of the accessibility of the earnings for Roth and then also the balances for traditional IRAs, you want to think about that.

Benz: Maria, helpful as always. Thank you so much for being here to share your insights.

Bruno: Thank you, Christine. Good to be here.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.

Watch “Tips for Last-Minute IRA Contributions” for more from Christine Benz.