17
Morningstar FundInvestor
April 2
014
and leaving your money there—that is, not convert-
ing those assets to a Roth—is almost never a good
idea. Yes, the Traditional nondeductible
IRA
gives
you tax-deferred compounding, but you can also get
that by buying tax-efficient investments inside your
taxable account. Moreover, the tax treatment on long-
held taxable assets (the capital gains rate) is more
attractive than the tax on
IRA
distributions, where
you’ll pay your ordinary income tax rate on any money
that hasn’t been taxed yet.
Mistake 4
| Assuming a backdoor IRA contribution
will be tax-free.
Although the nondeductible
IRA
isn’t valuable as a
buy-and-hold vehicle, it does have some benefits as a
conduit to a Roth
IRA
. The idea is that even if you
earn too much to contribute to a Roth
IRA
directly, you
can open a Traditional nondeductible
IRA
and convert
it to a Roth; there is no income limit on Traditional
nondeductible
IRA
s or conversions. Assuming you
have no other
IRA
assets, the only tax you’ll owe
when you convert from Traditional to Roth will be on
any appreciation in the assets that occurred from
the time you opened the account to the time
you converted.
However, the backdoor conversion may not be a good
idea if you have other
IRA
assets that haven’t been
taxed yet—for example, money that you rolled over
from a Traditional
401
(k) with a former employer.
In that case, the taxes due on the conversion will be
based on the ratio of already-been-taxed
IRA
assets
to those that have never been taxed (pretax contribu-
tions, including Traditional
401
(k) rollover money,
and investment earnings). If the former number is
much smaller than the latter, your conversion will
be mostly taxable.
Mistake 5
| Falling prey to analysis paralysis.
You practically need to be a certified financial planner
or tax professional to get your head around the
maze of rules governing the various
IRA
types: Income
limits and tax treatment of contributions and with-
drawals vary significantly. But don’t let the fear of
selecting the wrong
IRA
wrapper keep you from
making any decision at all. If you make an
IRA
contri-
bution that later proves ill-advised (for example,
you funded a Roth
IRA
when you earned too much to
contribute to one), you have a valuable escape hatch
called recharacterization, essentially a do-over for
IRA
investors. Recharacterization doesn’t enable you to
undo an
IRA
simply because your investment choices
were off the mark, but it does enable you to switch
to the
IRA
wrapper you should have chosen in the first
place—Roth instead of Traditional or vice versa.
Mistake 6
| Not contributing later in life.
It’s true that as you get older, any investment contri-
butions will benefit less from compounding than
would contributions you made earlier in your invest-
ment career. We’ve all seen the examples showing
how the individual who starts at age
22
has $
7
million
at age
60
, whereas the person who waited until age
40
to start investing has about $
12
,
000
. (
OK
, I’m exag-
gerating.) In a related vein,
IRA
contributions made
later in life will benefit less from tax-free (Roth) or
tax-deferred (Traditional
IRA
) compounding than will
contributions made earlier in life.
That’s not to say you should forget
IRA
contributions
in the years leading up to and during retirement,
however. For one thing, you may have
20
years or
more of tax-advantaged compounding left. And if
you’re investing in a Roth
IRA
, you won’t need to take
distributions from your account unless you need the
money (that is, there are no required minimum distri-
butions), so your money could continue to compound
even after you’re retired. Remember that you can start
contributing an extra $
1
,
000
to an
IRA
at the begin-
ning of the year in which you turn age
50
(for a total
contribution of $
6
,
500
). And even though you can’t
fund a Traditional
IRA
once you’ve reached age
70 1
/
2
,
you can contribute to a Roth at any age, as long as
you or your spouse have enough earned income to
cover the contribution amount.
œ
Contact Christine Benz at
