Avoid These Mistakes With Your IRA, Part 1

Funding an IRA may seem like a simple financial task: Pick your provider, send in your money, and choose your investments. Done.

But a look at Internal Revenue Service Publication 590, which details the ins and outs of IRAs, suggests there's more to it. There are two key IRA types (Traditional or Roth), as well as two subtypes of Traditional IRAs (deductible and nondeductible), not to mention byzantine rules regarding rollovers, conversions, and recharacterizations. And what about when you begin taking IRA withdrawals in retirement? More kooky rules there, too.

There are a few obvious IRA mistakes, such as pulling money out of a Traditional IRA before age 59 1/2, but here are some IRA pitfalls that might be less familiar.

Mistake 1: Not taking full advantage of the tax benefits. One of the key benefits of any type of IRA, whether Roth or Traditional, is the ability to avoid taxes as the money grows. Investors who hold stocks and bonds in a taxable account are likely to receive taxable income and capital gains distributions from their holdings each year. Investors who hold the assets in an IRA, by contrast, have the potential to be taxed at a lower rate, or not at all, on those payouts, assuming they don't take the money out prior to age 59 1/2. That represents an opportunity to stash high-income-producing securities, such as dividend-paying stocks, for example, within the IRA wrapper, while saving more tax-efficient assets, such as broad market equity index funds, in taxable accounts.

Mistake 2: Being dogmatic about asset location. The key consideration here is when investors expect to need the money. For young accumulators, IRAs may be stock-heavy, and there may be no reason to add income producers into the mix. Meanwhile, for a 35-year-old holding bonds to fund a remodeling project, for example, it may make more sense to hold them in a taxable account, without any strictures to withdraw the money before retirement. The same reasoning applies to retirees who would like to pull some money for living expenses from their taxable accounts. It doesn't make sense to have all of the bonds residing in an IRA; bonds' relative liquidity might be helpful in taxable accounts, too. Finally, it's worth noting that it's often desirable to tap Roth assets toward the back end of retirement—if at all—because their tax-saving features are generally the greatest and should be stretched out for as long as possible.

Mistake 3: Not giving due care to IRA beneficiaries. The importance of beneficiary designations (they actually trump other bequests laid out in estate plans) is an under-discussed topic. As with any type of beneficiary designation, it's important to keep your IRA beneficiary designations up to date as your life situation changes—marriages, divorces, parents passing away, and so forth. Most people will name their spouses as their IRA beneficiaries; when the account owners die, their spouses can generally roll the assets into their own IRAs.

Mistake 4: Triggering a tax bill on a Roth IRA withdrawal. One of the key benefits of funding a Roth IRA is the ability to take tax- and penalty-free withdrawals in retirement. The Roth may also be a great vehicle for accumulators who worry about tying their assets up for a long time, as it's possible, under certain conditions, to withdraw contributions at any time and for any reason without triggering taxes or a penalty. Things get more complicated, however, when it comes to withdrawing investment earnings, or if your money got into the Roth because you converted it from a Traditional IRA or 401(k).

Mistake 5: Triggering a tax bill on a rollover. When it comes to the financial tasks that might crop up on your to-do list during your investment career, an IRA ranks as easy on the degree-of-difficulty scale. But it's still possible to goof up a rollover.