Hey! It’s just an IRA. What is there to know? You put money in and it’s a tax deduction, you get to take it out after 59 ½ without paying a penalty, and at 72 the IRS makes you take some out. What else could there be?
In reality, there’s a lot more. Besides being able to contribute $6,000 every year, or $7,000 if you’re over 50, IRAs make up one of the major sources of retirement savings in the United States. The Investment Company Institute says there was more than $11 trillion in IRAs in 2020. And when you look at the rules governing IRAs, there are lots of potential mistakes that will leave you with substantially less money, putting a serious dent in your retirement income. Morningstar has come up with a list of IRA land mines and ways to avoid them.
Waiting Until the Last Minute to Contribute
Investors have until April 15 of the current year to make an IRA contribution for the previous year. As humans, we tend to procrastinate, and making IRA contributions is no exception. A study from Vanguard says waiting until the last minute may create a procrastination penalty. Investing on April 15 rather than January 1st of the previous year gives you 15 months less time for that contribution to work for you. For example, investors who waited until early 2021 to make their contributions missed an 18% return from the S&P 500. If you can’t make the full contribution at the beginning of the year, set up a monthly automatic investment into your IRA.
Assuming Roth Contributions Are Always Best
The attributes of a Roth IRA may seem like it’s always the best idea—contributions go in tax-free and as long as you wait until 59 ½ money comes out tax-free. But that’s not always the best option. Even though you always pay taxes on withdrawals from a Traditional IRA, your tax rate during retirement may be lower than during your working years meaning you got a tax deduction for making a Traditional IRA contribution and a smaller tax bill during retirement. That may offset the tax-free in and out aspects of the Roth.
Thinking of It as an Either/Or Decision
Deciding whether to contribute to a Roth or Traditional IRA depends on your tax bracket today versus what it will be in retirement. If you have no idea, it’s reasonable to split the difference. Invest half your contribution into a Traditional IRA (deductible now, taxable in retirement). Put the other half into a Roth (after-tax dollars in, tax-free on the way out).
Making a Nondeductible IRA Contribution for the Long Haul
If you earn too much to contribute to a Roth IRA, you also earn too much for a deductible Traditional IRA contribution. The only option open to all taxpayers is a Traditional IRA nondeductible contribution. There are two drawbacks to the nondeductible option: Required Minimum Distributions and ordinary income tax on withdrawals. The main advantage of a nondeductible IRA is using it to make a Roth IRA contribution when your income prohibits it. This is referred to as a backdoor Roth. You make a contribution to your nondeductible IRA and then immediately convert it to a Roth IRA. No income limits apply to Roth conversions, so it’s a way to make a Roth contribution when your income is too high to allow it.
Assuming a Backdoor Roth IRA Will Be Tax-Free
The backdoor Roth IRA should be a tax-free event. After-tax money was contributed. The immediate conversion should have little or no gains. But because of the pro-rata rule, the conversion may be taxable.
The Pro-Rata Rule prevents people from only converting non-deductible IRAs to Roth IRAs and thus avoiding the taxes that would normally be involved in the conversion process. This rule requires you to consider ALL of your IRAs as the same account. If you have substantial Traditional IRA assets the backdoor Roth conversion may be taxable.
Assuming a Backdoor Roth IRA Is Off-Limits Because of Substantial Traditional IRA Assets
But don’t automatically dismiss the backdoor Roth IRA. If your employer’s 401(k) accepts IRA rollovers, it removes them from the calculation used to determine whether the backdoor IRA is taxable. And even if getting into a Roth IRA via the backdoor may trigger some taxes after the conversion due to the pro-rata rule, that doesn’t necessarily cancel the benefits of doing it.
Not Contributing Later in Life
With the passage of the Secure Act, the age cap on Traditional IRA contributions was removed. Now, no matter your age, you can make a deductible Traditional IRA contribution as long as you have earned income.
There has never been an age cap for Roth IRAs. Making Roth contributions later in life can be particularly attractive if you don’t expect to need the money during retirement, but intend to pass it on to your heirs.
Forgetting About Spousal Contributions
It escapes many people that IRA contributions can be made for a non-working individual. As long as the working spouse has enough earned income to cover the total amount contributed for both of them, the couple can make IRA contributions for both individuals each calendar year.
Delaying Contributions Because of Short-Term Considerations
Investors—especially younger ones—might put off making IRA contributions, assuming the money will be tied up until retirement. Not necessarily. Roth IRA contributions can be withdrawn at any time for any reason without taxes or penalty. While it’s not ideal to raid an IRA prematurely, it’s better than not contributing at all.
Not Considering the Five-Year Rule
The ability to take tax-free withdrawals from a Roth IRA in retirement is the key advantage of having a Roth. But just because you’re at least 59 ½ doesn’t mean you can take investment earnings out of your Roth tax-free. You have to consider the five-year rule which says tax-free withdrawals begin at least five tax years after the first contribution is made to any Roth you own. If you take investment earnings before the five-year period, be prepared to pay income taxes and a 10% IRS early withdrawal penalty.
There’s a second five-year rule that determines whether the distribution of principal from the conversion of a traditional IRA or a traditional 401(k) to a Roth IRA is penalty-free. (You’re supposed to pay taxes when you convert from the pre-tax-funded account to the Roth.) As with contributions, the five-year rule for Roth conversions uses tax years, but the conversion must occur by Dec. 31 of the calendar year.
For instance, if you converted your traditional IRA to a Roth IRA in Nov. 2019, your five-year period begins Jan. 1, 2019. But if you did it in Feb. 2020, the five-year period begins Jan. 1, 2020. Don’t get this mixed up with the extra months’ allowance you have to make a direct contribution to your Roth.
Thinking of an IRA As ‘Mad Money’
Many investors begin saving in their 401(k)s and start building sizable balances. To them, IRAs are considered an also-ran investment vehicle making it easy to fall into the trap of considering an IRA as a place for niche investments. However, with regular contributions and investment growth, an IRA can grow into a substantial amount too. So, it makes sense to use a diversified approach in your IRA just like you do in your 401(k). Don’t think of your IRA as a place just for alternative investments and cryptocurrency
Missing Out on the Chance to Fill Holes
It’s a fact that investment options in company retirement plans do not cover all investment categories. If that’s where most of your retirement assets are then an IRA is a place to fill the gaps. Employer-sponsored plans offer core stock and bond funds and target-date funds, but seldom do they provide investments in Treasury Inflation-Protected Securities (TIPS), real estate, or commodities. These categories are easily added to an IRA.
Doubling Up on Tax Shelters
Putting tax-sheltered investments into an IRA is almost always a mistake. Remember, the IRA is already tax-sheltered. When you have investments with tax-sheltered features, it’s costing you. For example, municipal bonds should not go into an IRA. You’re receiving lower interest on municipals because of the federal and/or state taxes you don’t pay. In an IRA, that creates a double tax shelter and you lose. Another example is annuities. They are tax-sheltered and you pay high internal costs for that shelter. Not a good fit inside an IRA.
Not Putting the Best Investments in an IRA
How do you take full advantage of the tax benefits of an IRA? As the old Templar Knight said in Indiana Jones, “Choose wisely.” Use your Traditional IRA to house high-yielding income investments such as high yield bonds and REITs. On a taxable basis, that income would be taxed in the year it’s earned as ordinary income. In your IRA, tax on the income is deferred until later when withdrawals may be taxed at a lower rate because you’ve retired and may be in a lower tax bracket. Stocks with great appreciation potential would be a good fit for a Roth IRA, which offers tax-free withdrawals.
Triggering a Tax Bill on an IRA Rollover
There are two types of rollovers. First is the direct rollover. Your money goes from one tax-deferred account to another and it is a non-taxable event. The second is the indirect rollover. You take possession of the money being rolled over and as long as you put it into another IRA within 60 days, that is also a non-taxable event. But if you miss the 60-day window you’ll pay federal and state taxes on the entire amount plus a 10% early withdrawal.
Not Being Strategic About Required Minimum Distributions
Beginning at age 72, the IRS forces you to take Required Minimum Distributions from your Traditional IRA. They want tax money on all that money you haven’t paid taxes on yet. But it’s an opportunity to rebalance your IRA portfolio. You can sell highly appreciated stocks to cover the RMD and reduce your risk level at the same time.
Not Reinvesting Unneeded RMDs
So, the IRS makes you take an RMD every year beginning at 72. What happens if you pay the taxes and have money left you don’t need? You could put it in a taxable account using tax-efficient investments, or if you have earned income, put the money into a Roth IRA where taxes on investment income and capital gains is not an issue.
Not Taking Advantage of Qualified Charitable Distributions
Being forced to take an RMD every year and pay taxes is certainly a grumbling point. But there’s a way to meet the RMD and not pay taxes on it. You can use a Qualified Charitable Distribution, also known as a Charitable Rollover. As long as you are age 70 ½ or older, you can send your RMD directly from your IRA to any IRS-qualified charity. The charity gets the benefit and you don’t pay taxes on it. Because you can’t claim it as income you also can’t claim the amount as a charitable donation.
You can give up to $100,000 each year using the QCD and if your spouse has an IRA, they can also give up to $100,000 annually.
Not Paying Enough Attention to Beneficiary Designations
When you set up an IRA you have to name a beneficiary. Doing so makes sure the people you want to benefit from your IRA actually get the money. And because you name a beneficiary, your IRA amount is not included in your estate. But a large percentage of IRA owners are guilty of “Set it and forget it.” Most never review their beneficiary designations again. That can be a disaster. For example, if you remarry after a divorce and don’t remove your ex-spouse as beneficiary of your IRA, your ex will get your IRA when you die because that’s whose name is on the beneficiary form and there’s nothing your current spouse can do about it. Review your beneficiary designations every year to see if anything has changed.
Not Seeking Advice on an Inherited IRA
Besides the Traditional IRA and the Roth IRA, there is also an Inherited IRA, one you receive at death because you were named beneficiary. The Inherited IRA has different rules depending on your relationship to the deceased and making a move without knowing what rules apply to your situation can trigger a big tax bill. It’s a good idea to consult with a tax or financial professional before you do anything with an IRA you inherit.
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