The US Individual Retirement Arrangement / account (IRA) is one of the world’s simplest, cheapest, most flexible, world-class tax shelters in which to save and invest for retirement. While the individual IRA contribution limits for 2019 have been raised to US$6,000 ($7,000 if you’re age 50 or older), some higher earners find these limits relatively low despite how easy it can be to build up a $1,000,000+ IRA. In this post, 5 days before the April 15 contribution deadline for 2018, I wanted to list out 19 of the top IRA mistakes I’ve seen US taxpayers make as of early 2019.
Mistake #1: Not putting money into an IRA when you’re eligible
This is by far the biggest and most important IRA mistake, as everything else I might say on how you invest or withdraw your IRA is pointless if you never actually put money into it in the first place. As a general rule, if you have earned income (i.e. from a job, not investment income) that could be subject to US tax (i.e. not excluded by the foreign earned income exclusion, though possibly offset by other deductions), you should be able to make an IRA contribution.
A common mistake I hear from Americans living and working overseas is the belief that US expats either can’t contribute (see mistake #2), or make too much to contribute to an IRA. To be clear, there is NO UPPER LIMIT ON YOUR INCOME that would stop you from making some form of IRA contribution, though higher earners may not be able to contribute directly to a Roth IRA. What does change is that is that if you make more than about US$70k/year AND you are covered by a US-qualified retirement plan at work (like a 401k, which very few overseas Americans have, though contact me if you’d like help setting one up).
In short, if you pay US tax on a salary or bonus you earned, you should put some of that into an IRA.
Mistake #2: Putting money into an IRA when you’re not eligible
Less common, but still a mistake, is making IRA contributions in years you are not eligible. This generally happens when either a.) you have less than a few thousand dollars’ earned income in a year, or b.) all your earned income was excluded from US tax by the foreign earned income exclusion. Excess contributions are subject to a penalty of 6% per year until withdrawn.
Mistake #3: Not considering a SEP IRA, if you’re eligible
SEP IRA stands for “Simplified Employee Pension”, and is a super-simple and low cost alternative to a 401k plan. Contrary to popular misconception, SEP IRAs are not only for the self-employed, but can be set up by any employer of eligible US employees. The main reason larger companies tend not to set them us is that the simplicity comes with rigid rules:
- The employer must make all contributions, no employee elected contributions like in a SIMPLE IRA or 401k
- The employer must contribute the same percentage of income into the SEP accounts of all eligible employees
- Employer contributions must 100% vest immediately
If you are in a position to set up your pension as employer contributions into a SEP, this is a simple way to contribute about 10x as much (about US$55,000) as into a regular IRA.
Mistake #4: Not considering Roth conversions
One mistake I admit I myself have made too much of is not doing enough Roth conversions in years my income was relatively low (and so when I was in a relatively low US tax bracket). A Roth conversion allows you to pay taxes on your IRA one time in the current year, and convert the IRA into a tax-free account no longer subject to required minimum distributions (RMDs) for life. If your income is too high to make Roth contributions, Roth conversions of recent contributions are sometimes also known as the “backdoor Roth IRA”.
Earlier I posted a Roth IRA conversion calculator for running the numbers on when a conversion makes sense.
Mistake #5: Keeping too many different IRA and 401(k) accounts
“Too many accounts” is a common mistake, not just for IRAs, but for many different types of investment accounts. Here, the mistake is most often keeping too many old 401k accounts with old employers, rather than taking the opportunity to consolidate all these old pensions into a single IRA account that is easier to manage. In an earlier post, I explain why transferring a 401(k) to an IRA is an important to-do for those moving overseas after working in the US.
Mistake #6: Not considering advantages of the 401(k) over an IRA
Although I generally advocate consolidating 401(k) accounts into an IRA, I am cautious about the asset protection advantages ERISA plans like 401k’s provide over IRA accounts. This is why I sometimes keep “Rollover IRAs” funded from 401k accounts separate and avoid mixing these with individual IRA accounts. While I would like to say this is mostly an issue for those of us in lawsuit-prone professions, many of us never know when we might need asset protection before we do.
Mistake #7: Withdrawing from an IRA before age 59 1/2
Withdrawals from an IRA before age 59 1/2 are generally subject to a 10% penalty in addition to ordinary income taxes. While there are exceptions, some of which are more generous for Roth IRAs, it rarely makes sense to pay this penalty and reduce what you’ve saved to live on in retirement.
The most common question I get about this is from non-Americans / non-resident aliens with 401k / IRA accounts from jobs they worked in the US, and what they should do with these after they leave if they have no plans to ever return to the US. The answers can depend on your circumstances, so please feel free to contact me or your advisor to discuss.
Mistake #8: Withdrawing from an IRA too soon after age 59 1/2
Just because you can make penalty-free withdrawals from an IRA starting at age 59 1/2 doesn’t mean it’s best for you to do so. Having money and investments in an IRA is one of the world’s best tax shelters, and it is an advantage to keep as much in there to reinvest and grow tax-deferred (or tax-free for a Roth) as long as you can.
Mistake #9: Not preparing for required minimum distributions (RMDs) starting at age 70 1/2
After seeing the advantages of keeping assets in an IRA to grow and reinvest tax-deferred long after age 59 1/2, the bad news is that the IRS will require you to start taking a minimum percentage out of your non-Roth IRAs starting at age 70 1/2 (so that they can start taxing you on it). Although there is little you can do to prevent aging, you can prepare for it to make this tax bite more manageable. Some strategies include:
- Doing Roth conversions (see #4) so less or no IRA is subject to RMDs
- Scheduling your other income so that the RMDs hit at a lower tax bracket, if possible
Mistake #10: Withdrawing from an inherited IRA too soon
In the unfortunate event a loved one passes away and leaves an IRA with you as a beneficiary, some IRA custodians / brokers may suggest that you withdraw the IRA sooner than you need to. Under current law, a beneficiary can transfer an inherited IRA into a separate inherited IRA account, where they are then allowed to “stretch” required minimum withdrawals over a much longer period based on the beneficiary’s life expectancy. This is why inherited IRAs are sometimes known as “stretch IRAs”, and offer significant tax and wealth building advantages if you keep as much as possible reinvested in an inherited IRA and draw on them as slowly as possible. For more information on discussed proposals to end the advantages of the stretch IRA, I recommend the YouTube videos of Jim Lange on the possible “Death of the Stretch IRA”.
Mistake #11: Holding your IRA at a bank
Many banks will open an IRA account for you, but banks are generally the worst place to open or hold IRA money you don’t plan to spend in the next year. IRA funds are meant to be invested in long term stocks, bonds, and real estate investment trusts so that they provide you long-term growth and inflation protection, which bank products have not done in my lifetime.
Mistake #12: Doing Prohibited Transactions in a Self-Directed IRA
While many people think of an IRA as an “Individual Retirement Account“, technically it stands for “Individual Retirement Arrangement“. There are custodians and administrators that specialize in transferring your IRA or 401k to an account from which you can invest your IRA in physical real estate, private businesses, hedge funds, or other exotic investments, which may be tax efficient, but not always the best idea financially.
Besides the administrative and compliance hassle, the biggest pitfall of self-directed IRAs are prohibited transactions, which often involve self-dealing (e.g. you can’t use your IRA to buy a house you live or) or debt (e.g. IRAs can’t borrow money on a recourse basis).
Mistake #13: Investing your IRA too conservatively
Related to #11, one of the biggest mistakes I see in retirement accounts of way too many young people (and by “young” retirement investor, I generally mean below age 50, sometimes below age 60) is having too much of their retirement accounts invested in cash or short-term bonds. Even a 70 year old can expect to need their retirement account to keep up with inflation for another 15 years, so there’s no reason a 30 or 40 year old should have less than about 70% of their retirement accounts in stocks, real estate, or other long-term assets.
Mistake #14: Investing your IRA too aggressively
On the other extreme of #13 is taking too much risk with your retirement account. Here I hear of people wanting to invest in bitcoin, tech stocks, or start-up companies. Retirement accounts are terrible things to gamble with, and remember, you get no tax deductible loss write offs on retirement accounts.
Mistake #15: Investing in things your IRA might have to pay tax on
The big advantage of an IRA is that it shelters your retirement savings from tax, so naturally, you’d want to avoid investments that are taxable, even to an IRA. The two big examples I’m thinking of here are:
- Master Limited Partnerships (MLPs), which can subject an IRA to Unrelated Business Income Tax or UBIT
- Foreign dividend paying stocks, subject to tax withholding IRAs do not get a foreign tax credit for
Mistake #16: Investing your IRA in things that are already tax-advantaged
An IRA is a great place to invest the portion of your overall portfolio that is relatively tax-inefficient. Ideal investments to put into an IRA rather than a taxable account include:
- US Real Estate Investment Trusts (REITs)
- High yield bonds
- High dividend stocks
- Trading strategies that generate short-term capital gains
One of the worst things you can put in an IRA are tax-exempt municipal bonds, since you could do those tax-free in a taxable account anyway. Low-dividend growth stocks could go either way, since they naturally provide deferral in a taxable account, but if the eventual gains are very large, you may have wanted that in an IRA account, especially a Roth.
Mistake #17: Prioritizing 529 contributions over IRA contributions
Parents who love their children often make it a priority to save for their childrens’ college tuition / university fees, sometimes even at the expense of their own retirement. While I hope you are able to comfortably save for both retirement and children’s education, if you ever have a tight year where you can only do one, invest for retirement first, then college. As much as we may hate student debt, remember that there are such things as student loans, but there is no such thing as a retirement loan (I don’t count reverse mortgages).
Tax-wise, a 529 college savings plan looks and acts much like a Roth IRA (no deduction for contributions, but potential tax-free growth), but can be drawn at any age for qualified educational expenses, and is only tax free for qualified educational expenses, not general retirement expenses.
Mistake #18: Not complimenting an IRA with an HSA
I continue to be surprised by how few Americans I meet that have HSAs. An HSA health savings account is in some ways better than an IRA, in that it provides you with a tax deduction on the way in, as well as possible tax-free withdrawals for qualified medical expenses on the way out, with the same tax-sheltered growth in the meantime. The most difficult requirement for many is to have a qualifying high-deductible health plan, which I recommend most professionals have anyway.
Mistake #19: Leaving it to the last minute
Last but not least, I thought I’d end these points with one I’ve left to the last minute in writing this 5 days before the 2018 IRA contribution deadline. For some reason, I still see most clients waiting until March or early April for the year before, but unless you are that unsure of your income, why not get started with your 2019 contribution now, and be ready to put in for 2020 in January, rather than stressing about whether your wire transfer completes by April 15th?
Hopefully these 19 points inspired you to make the most of your IRA and other investment accounts from 2019 and beyond. As always, feel free to leave a comment below or contact me with any questions.