How to Avoid IRA Pain Points
Overcoming common missteps on the road to retirement success.
Many people wait until the last minute to make annual IRA contributions, even when they have the cash available. According to Vanguard, roughly two-thirds of IRA contributions in 2016 came into the firm in the year's first four months, and most of those contributions were earmarked for the 2015 tax year, not 2016. Furthermore, IRA contributors do not tend to just procrastinate in funding their accounts. They also procrastinate in getting the money invested once it is in the account. Last-minute IRA contributions often go into money market funds and remain there several months later.
By making the contributions each April, investors delay more than a full year beyond when they are first eligible to make those contributions. For older investors and those who are contributing to lower-returning investment classes, the opportunity cost of delayed contributions is not that great. But the opportunity costs, both in terms of foregone returns and tax advantages, stack up when the contributions are delayed year after year and the market performs well. To illustrate, a procrastinator could inadvertently dock her return by nearly $28,000 if she delayed her contributions each year over a 35-year period in which market returns were excellent. And, 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, consider means of removing 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.
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 would make their contributions each spring. Other IRA contributors may be waiting to see what their modified adjusted gross incomes are, as that is the figure that determines whether they can invest in a traditional deductible IRA, a Roth IRA, or must go the “backdoor” route (i.e. making a traditional nondeductible IRA contribution and then converting it). But for many, the delayed contributions simply amount to procrastination.
How to avoid it: Making contributions when you are first eligible—January 1 of the tax year in question—is the best way to harness both investment compounding and the tax benefits of the IRA. For some investors however, coming up with $6,000 to invest ($7,000 if you are over 50) can be a challenge. One means to help make IRA contributions more manageable is dollar-cost averaging into an IRA—contributing enough each month to hit the maximum allowable annual 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 is $583 per month. Do not let concerns about making the “correct” IRA type (Roth or traditional) hold you up. While re-characterizing a Roth IRA to traditional, or vice versa, is no longer allowed following a conversion, you can still re-characterize 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 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 is 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 minimal. 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 are investing in a backdoor Roth IRA, leaving the money in cash until you have undertaken the conversion is reasonable. Otherwise, it is best to craft a plan to invest your IRA contributions in long-term securities straightaway. One option 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.
To learn the best approach for you to improve your IRA funding, talk to your Financial Advisor.
© Morningstar 2019. All Rights Reserved. Used with permission.
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