(PUB) Morningstar FundInvestor

April 2 014

Morningstar FundInvestor

17

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. 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 4 | Assuming a backdoor IRA contribution will be tax-free.

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. 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 christine.benz@morningstar.com Mistake 6 | Not contributing later in life.

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