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By Jason Stipp and Christine Benz | 02-24-2014 11:00 AM

10 Missteps With Tax-Sheltered Accounts
IRAs, 401(k)s, and Roth accounts are key components of your toolkit,
so make sure you get the most out of them.
Jason Stipp: I'm Jason Stipp for
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See More From Morningstar's Tax Relief Week
Morningstar. It's Tax Relief Week on
Morningstar.com, and today we're
helping you maximize tax-sheltered
accounts, specifically by avoiding some
pitfalls in those accounts.
Here to talk about some of common
mistakes, and uncommon mistakes, is
Christine Benz, our director of personal
finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: Christine, there are a lot of big mistakes that seasoned investors know,
such as missing out on the company match in a 401(k), but you also have some
maybe lesser-known mistakes that you can make in these accounts that could
ultimately help investors save some tax dollars.
opportunities are surfacing, as well.
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Benz: It's not the case at all. I think people can really get a lot of mileage out of
The first one is reflexively reaching for a Roth account. Roth accounts have a lot of
great benefits, but they're not right in every single situation.
Benz: That's right. The keep profile for whom a traditional deductible IRA will tend
to make the most sense is someone who is getting close to retirement and hasn't
yet saved a lot. That person may in fact be in a higher tax bracket today than they
will be when they are retired. In that case that tax deduction that you get when
you make your contribution is going to be more beneficial for you than it will be in
retirement. You may be in a much lower tax bracket in retirement than you are
today.
Stipp: A possible second mistake can occur when converting assets from
traditional IRAs to Roth. You need to be careful when you do that, especially if you
have other traditional IRA assets.
Benz: That's right. It gets complicated. A lot of people have been enthusing about
what's called the backdoor Roth IRA. That means that you open a traditional
non-deductible IRA and then you convert that to a Roth. You can do that at any
income level, which is why it has gained some excitement among higher-income
investors.
The key thing you need to be aware of is, if you have other IRA assets, traditional
IRA assets, that have not been taxed yet, the tax treatment that you'll incur when
you do that conversion will be based on your ratio of monies that have never been
taxed to new IRA assets. So you want to be careful. You may want to check with a
tax advisor to see whether that backdoor Roth idea makes sense for you.
Stipp: Another mistake when it comes to doing these conversions is thinking that
it's an all-or-nothing prospect--that you have to convert every single bit of your
traditional IRA to Roth--but that's not the case.
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doing partial conversions, which are completely allowable. The beauty of a partial
conversion is that you can convert just enough so that you don't push yourself into
a higher income-tax bracket for the year in which you do the conversion.
Work with an accountant on this. If you have a lot of IRA assets that you want to
convert, it can be a great strategy to do it piecemeal over a period of many years.
Also bear in mind that you do have an escape hatch. You can do a
re-characterization--essentially a do-over--if you do a conversion and the timing in
hindsight turns out not to have been right.
Stipp: The next mistake that some investors might make, or maybe a lot of
investors, is waiting until the last minute to fund an IRA account for the prior tax
year. Why might you not want to wait until early April 2014 to do your 2013
contribution to an IRA account?
Benz: Incidentally, that's what Vanguard has found. When it looked at when
people have contributed, it found that a lot of people rush the doors right before
that tax-filing deadline.
Foregone compounding is really the main reason that you don't want to do that.
Think back to the beginning of 2013; if you had only made that contribution at the
outset of 2013 instead of waiting until now to make it, you would have had a
year's worth of great appreciation. This is particularly important for younger folks
with longer time horizons. That benefit of compounding when multiplied over many
years can really add up.
Stipp: Turning to 401(k) plans: Of course a big mistake is not at least contributing
enough to get your employer match, but when you contribute can also affect the
kind of match that you get, and people can miss out on a match in certain
situations.
Benz: That's right. This is kind of a high-class problem. It's something that higher-
income people sometimes run into, where they max out their 401(k) plans very
early in the year. What happens is that they haven't taken full advantage of
employer matching contributions, which are usually spaced out on a per-pay-period
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basis. So you want to be careful: If you've earned a bonus and you're contributing
at a very high level, you could actually not benefit from your full employer
matching contributions.
Some plans have instituted a provision that actually will give employees full
matching if they have maxed out their contributions, even if they've done so in the
first part of the year. But check with your plan. If your plan does not have such a
provision, you want to be careful to space out your contributions pretty evenly.
Stipp: Mistake number six involves not considering how a possible Roth 401(k)
option could be beneficial for you when you do reach retirement.
Benz: For a lot of people, splitting the difference between traditional 401(k)
contributions and Roth 401(k) contributions can be the way to go, because really
what you have to decide when you choose which type of contribution to make is
what sort of tax bracket you will be in during retirement versus where you are
now. A lot of people say, I have no idea--especially younger earners. For them,
splitting between the two account types, which is usually an allowable option, is
the way to go.
Stipp: Another mistake involves a different kind of tax-sheltered account, the HSA
or the health savings account. Some investors may say, I'm not going to use the
HAS; it's not for me. But there could be benefits for some folks here.
Benz: Health savings accounts are used in conjunction with high-deductible
health-care plans. A lot of people might say, I don't want to pay the deductibles out
of pocket, or it's just more complicated than investing in the traditional health-care
plan, and that's all true.
But particularly people who are healthy and wealthy--so, who are already maxing
out their other tax-sheltered vehicles and are in pretty good health, and probably
won't have a lot of out-of-pocket health-care costs--for them, HSA can be a really
nice tool in their toolkit.
In particular, it has three tax-saving benefits. You make pretax contributions, you
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enjoy tax-free compounding on the money, and then assuming that the
withdrawals are for qualified health-care expenses, that money is tax-free, too. So
it's one of the only triple-tax-benefited accounts in the whole tax code.
Stipp: Mistake number eight also involves 401(k) plans, and that's automatically
rolling over the 401(k) to an IRA when you retire or when you switch jobs. There
are a lot of good reasons to do that, but there are also some reasons to keep
money in the 401(k) plan in certain circumstances.
Benz: I often say the rollover is the best answer in part because you can get away
from that extra layer of fees that accompanies a 401(k) plan and isn't there with
an IRA. But if you are in one of a couple of different categories, you want to steer
clear of the rollover and instead stay put in the 401(k).
The first is if a lot of your 401(k) assets are in company stock: Check with an
accountant on this, but oftentimes it will be better to leave that money in the
401(k), because you'll be able to enjoy capital gains treatment on the money when
you begin withdrawing it in retirement.
The other category is for people who are between age 55 and 59 1/2 and they
want to begin withdrawing money from the 401(k) during that time period. They
may be able to begin withdrawing from the 401(k) before age 59 1/2; they can't
do that from an IRA without incurring a 10% penalty.
Stipp: A couple of portfolio planning mistakes: The first one is not thinking about
your asset location, or what types of investments you put into these accounts.
Benz: You want to keep in mind that you do enjoy tax-free or tax-deferred
compounding on your money. In general, if you have any sort of investment types
that are kicking off a lot of ordinary income, you want to make sure that you're
housing them within tax-sheltered accounts. You can hold other types of
assets--like index funds, for example, or municipal bond funds--in your taxable
accounts because they will tend to be very tax-friendly on a year-to-year basis.
So keep in mind that concept of asset location when you think about which types of
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investments to place where.
Stipp: But sometimes that asset location can change, especially as you move into
retirement?
Benz: That's right. So, in particular, you'd want to think about getting bonds
relocated into your taxable accounts because those are typically the first accounts
you'd want to deplete in retirement.
Stipp: So, there can be some twisting that happens as you get into retirement.
Benz: Exactly.
Stipp: The last mistake is not using taxable accounts. Even if you have
tax-deferred accounts, there are some reasons that you might want to have
taxable accounts, especially when you get into retirement?
Benz: That's right. One of the key reasons is that for some people--especially,
again, people who are in the higher-income bands--putting the full contribution
into the IRA and 401(k) just may not be enough given your income demands in
retirement. You will need to use taxable vehicles as well.
The other key reason to consider it is that, when you are actually retired and
you're beginning to withdraw those assets, you can really be quite strategic about
where you go for cash--which of your account types you'd tap for cash. And those
taxable vehicles, especially if you are paying a lot of attention to what types of
assets you're putting there, can be pretty tax-friendly on a year-to-year basis.
If you find yourselves in a very high-tax year and need to pull some money out,
you may be able to enjoy pretty low capital-gains treatment on the money that's
coming out of those taxable accounts. So, definitely tax diversification is a goal for
people who are getting close to retirement.
Stipp: Christine, the tax-sheltered account is one of the most important tools in
investors' toolkits. Thanks for helping us use those better today.
10 Missteps With Tax-Sheltered Accounts http://www.morningstar.com/Cover/videoCenter.aspx?id=636707
7 of 10 4/13/2014 10:22 AM
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
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sandsok
Feb 27 2014, 7:03 PM
I don't think that we are in a minority, but we don't make much
money for the companies and therefore we are NOT a priority. I
have watched for years and have yet to see any important
discussions on people who are already retired with the same assets
that "wazone" talks about.
chuck49
Feb 27 2014, 3:38 PM
Has anyone noticed how hyper this discussion was? It made me
nervous just watching it. Christine is usually a more relaxed
speaker, so perhaps this video was sped up to make info more
palatable to the gamer generation?
williamr
Feb 25 2014, 3:11 PM
Unless you are certain your retirement tax rate will be lower,
consider saving funds in all three basic type of accounts: taxable,
tax-deferred (traditional 401K/IRA), and tax-free (Roth 401K/IRA).
We have all three (80% in traditional IRA today), are over 70.5, but
made the mistake of draining the taxable account first (paid almost
no tax for a few years). We now only live off of the traditional IRA
(SS is not enough to pay the taxes on the withdrawals). It would
have been much smarter to pay more tax earlier by withdrawing
some traditional IRA funds immediately and slowing the withdrawal
rate of funds in the taxable account to keep us in a lower tax
bracket for a longer period of time. We keep the Roth IRA
untouched as a safety net for medical, long-term health care,
emergencies, or estate taxes.
Flipper
Feb 25 2014, 2:40 PM
@content and wazone:
You mean like this one?
http://news.morningstar.com/articlenet/article.aspx?id=636472
wazone
Feb 25 2014, 2:30 PM
I agree with "content"--OK on the 70.5 as described--but what if you
are 80.5 like me, when will we hear that discussion ?
Bruce47
Feb 25 2014, 12:56 PM
For me, the first question to ask regarding a 401(k) to IRA
conversion is whether the company will allow beneficiaries to
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continue new ownership in their respective pieces of a 401(k)
account when the retiree dies. If not, a very large and unavoidable
tax bill may come due! If so, the heirs can continue the tax deferred
status and make their own withdrawal and conversion decisions.
content
Feb 25 2014, 12:43 PM
When will you discuss tax savings issues for couples over 70.5, with
no earned income, just pension, SS, Dividends and CG? These folks
cannot put new money in IRAs, Roths, 401Ks, HSAs, etc. Or are we
in such a minority that it is not a priority on your list?


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