As the April 15 tax filing deadline approaches, procrastinators are scrambling to finish their 2013 tax year returns. The clock is also ticking for IRA contributions that will count for the 2013 tax year.
Investors who wait until the eleventh hour will forgo the benefit of timelier contributions, but this not the only mistake that can trip up even savvy investors when it comes to their IRA contributions.
A recent article on Morningstar lists six common errors investors make in addressing this important retirement savings vehicle:
Mistake 1: Waiting until the last minute
A large segment of IRA contributors for the 2013 tax year will lose 15 months of tax-advantaged compounding because they will have waited until the tax-filing deadline to make a contribution rather than doing so at the beginning of the tax year (Jan. 1, 2013), according to Vanguard research on the topic. Over time, missing out on this compounding benefit can add up to serious money. And even investors who fund their IRAs may delay in selecting their investments, which can also weigh on returns over time. Morningstar says younger investors, in particular, should make a point of getting their IRA contributions invested in long-term securities at the earliest opportunity.
Mistake 2: Thinking of Roth vs. traditional as an either-or decision
It can be a mistake to think about Roth and traditional in exclusive terms. Many investors end up with a blend of traditional IRA and Roth accounts, either by happenstance or by design, according to Morningstar. For example, someone who could contribute to a traditional IRA in the past may no longer be able to deduct the contribution because of income limits, but can still fund a Roth IRA.
Moreover, the idea of tax diversification argues for building balances in taxable, tax-deferred and Roth accounts. For one thing, few investors can forecast whether their tax rates will be higher or lower in retirement than they are now, so holding multiple accounts is a good way to hedge against multiple outcomes. Income levels during working years may also fluctuate: A low tax-rate year can be a good time to fund a Roth, while a deductible traditional IRA contribution can be more valuable when your tax rate is higher. In addition, holding taxable, Roth and tax-deferred accounts gives a retired investor the ability to obtain varying tax treatments of withdrawals, thereby keeping taxable income lower. Investors can even split their contributions among each account type in a single tax year, so long as total contributions don’t exceed $5,550 for those under 50 and $6,500 for those older than 50.
Mistake 3: Making a nondeductible IRA contribution for the long haul
Investors who earn too much to fund a Roth IRA (and by extension earn too much to deduct their traditional IRA contribution because of even lower income limits) can still open a traditional account and then convert it to a Roth — a potentially valuable maneuver for many high-income savers because there are no income limits on conversions. But opening a traditional, nondeductible IRA and not converting those assets to a Roth is almost never a good idea, according to Morningstar. True, the traditional IRA provides tax-deferred compounding, but that can also be had by buying tax-efficient investments inside the taxable account. Moreover, the capital gains rate on long-held taxable assets is more attractive than the tax on IRA distributions, which will incur ordinary income tax rate on any money that hasn’t been taxed yet.