The Best and Worst Times to Fund an IRA
Most philosophical questions in personal finance can find a sound answer in the words of Warren Buffet and Charlie Munger. On the topic of market timing, the Oracle of Omaha famously said, “The best time to buy is when you have the money. The best time to sell is never.” But is that really the best advice for your IRA?
Left and Right Limits
If we want to know when the best time to contribute to an IRA is, let’s start with the boundaries of the issue that we can’t control. Per IRS rules (which come from Congress, so vector your hate thrust appropriately…) You can contribute up to $6,500 (plus $1K over age 50) to your 2023 IRA when you have at least that amount in earned income and contribute between 1 January 2023 and 15 April 2024.
Seems pretty simple, right? Let’s look at earned income first. For all my flying steely eyed killers, your salary qualifies as earned income. So does self-employment income from jobs such as dog walking (for the young and young at heart) and defense consulting like the part-time side hustles we do to bridge the gap between a steady military salary and life 2.0 in the airlines.
While it may not feel like salary, if you rely on a tax refund to contribute to an IRA, that’s (usually) your salary coming back to you after Uncle Sam enjoyed a negative interest loan for the year, so you can contribute that too.
Plenty of income sources don’t count though. Your kids can’t use gift money. You can’t use rental income from your slum lording empire (if it’s your only income). Likewise, if your only income sources are pensions, investment returns, or even distributions from an IRA such as an inherited IRA, you can’t put that money back into an IRA.
A stay-at-home spouse however, does not need to earn an income to fund an IRA. As long as one spouse earns enough to contribute to two IRAs, green light go for funding both.
Aunt IRS declares a new IRS open season each January 1st, but leaves the door open for the previous year until tax filing time. There’s a catch, however. While many of us need timeline extensions for filing our taxes each year, the deadline to contribute to a given year’s IRA is the personal tax filing deadline in April, not the extended deadline in October. The date you should remember is April 15 because it won’t be earlier even though the actual deadline shifts later by a day or so some years due to weekends and holidays.
Methods to Fund your IRA
Essentially, you have 15.5 months each year to fund your IRA, but when should you pull the trigger? Say it with me now, “it depends.”
The two most common techniques for funding IRAs are dollar-cost averaging (DCA) and lump sum investing (LSI). Dollar-cost averaging is the method of contributing a fraction of your IRA total each month or pay period. If you intend to contribute $6,500 in 2023, you’d contribute $541.66 each month or $270.83 each pay period (assuming the 1st and 15th).
LSI is just what it sounds like—contributing $6,500 all at the same time in one lump sum sometime between January 1st and tax time the next year.
The Pros of Dollar-Cost Averaging
DCA smooths out budget planning. Most families have a much easier time factoring in budget categories that involve a few hundred dollars each month, but the better part of ten thousand dollars can be a real budget-buster in any given month.
DCA offers the hope that sometimes, you’ll buy at a discount. If you purchase (hypothetical) mutual fund ARGH every month through out the year, it’s reasonable to expect that some shares will cost less than others due to market volatility. This drives down your average cost for all the shares you own, generally, allowing you to own more share and build more wealth over time.
DCA prevents market timing worry. If you set up automatic DCA, you can absolve yourself of worrying about market timing. You’re effectively admitting that sometimes you’ll buy at a discount, sometimes not so much, but at least you’re always buying. Uncle Warren would be proud!
DCA is predictable and easy to automate (for mutual funds, not so much for Exchange-Traded Funds (ETFs)). Automating our investment behavior is quite possibly the best way to prevent ourselves from defeating ourselves by actually investing for our future.
The Cons of Dollar-Cost Averaging
If you invested from 2009 to the end of 2021, you may have notice that the price of most securities seemed to move up, without a lot of down. DCA ensured that you put money in the market, but you might not have brought down your average purchase price by sequencing throughout the year. In a Bull Market, DCA can equate to buy high… then buy higher.
Without automation, you might not invest. DCA works best if you set up automatic investing. Otherwise procrastination, distraction, and their many friends can creep into your life and derail your plans to stash those dollars in your IRA.
Perhaps the best reason not to use DCA is the Backdoor Roth IRA Club. Because a Backdoor Roth IRA is both an IRA contribution and then a Roth conversion, timing matters. If you’re in the Backdoor Roth IRA Club because you make over $218K/$138K (married/single), you’ll want to be very intentional about funding your Backdoor Roth IRA. If you perform the contribution without an immediate conversion, you’ll probably experience investment gains or losses on your contribution. Investment gains prior to the Roth conversion result in a tip for the tax man. Investment losses… well, those just stink—and they complicate your accounting.
The Pros of Lump Sum Investing
One of the best axioms in investing is: time in the market beats timing the market. Research bears this out. Vanguard’s study on LSI vs DCA demonstrates that in most cases, we’re better off just getting our money into the market and letting it compound over the years rather than metering the flow.
The simplest way to view this in the IRA context is that $6,500 invested in early January 2023 has the opportunity for 15.5 months more of lifetime compounding than $6,500 invested on April 15th 2024. Over four decades of earning and contributing to IRAs, it’s reasonable to assume that extra time compounding will result in extra compounded returns. Actual results will of course, vary.
Returning to the Backdoor Roth IRA Club issue, LSI is the most common technique for executing Backdoor Roth IRAs for multiple reasons. First, if your income is higher, it’s likely that you have enough cash to just fire and forget on your IRA investment early in the year. This may not be true in your first year or so in the Backdoor Roth IRA Club, but as you adjust to higher levels of income, you can probably adjust your cash management to have $6,500 to $13,000 ready for an early-year contribution.
The second and more crucial reason goes back to the whole contribution then conversion rigmarole. We only have so much bandwidth for financial gymnastics throughout the year. If we’re having to log in 12-24 times per year (per spouse!) to make a contribution and then another 12-24 times to make a conversion, there’s a pretty high Pk that we’ll pork it up at least once, resulting in investment losses or earnings that defeat the best practices of Backdoor Roth IRA.
The Cons of Lump Sum Investing
While we can package it a of number ways, the case against LSI is that we just won’t do it. “The market is too high!” “The market is too low.” “I’m too busy.” “There’s a rock in my shoe.” “The sun was in my eyes.” The MK-1 human is excellent at rationalizing self-defeating behavior. We also legitimately get busy and leakers get by us.
We can conjure infinite excuses not to start or finish our IRA investment just yet, then suddenly the window closes and we lost that year’s opportunity.
LSI isn’t as easy to automate, especially given that the IRA limits change periodically. If you forget that a year ago you set up an automatic $6,500 to vanish from your checking account, could it ripple into a bounced check or declined debit card transaction? Ouch!
LSI feels more like market timing. Even though the math tells us that more time in the market is good, our lizard brain tells us that we could have just bought at the peak before a crash! That’s a powerful incentive to wait just a bit longer.
And the Winner is…
While the IRS tells us when we can fund our IRA, the meat sack in the mirror determines when we will fund our IRA. It turns out that the best time to fund your IRA is when you actually will do it.
If you feel better knowing that you surfed the market highs and lows with DCA, so you reliably executed DCA each year—awesome! Keep doing that…even when you join the Backdoor Roth IRA Club. Just be more diligent to do your conversions in the Backdoor Roth IRA Club.
If you get more satisfaction from the statistics, then LSI as early in the year as possible is your friend. Put it on your calendar, tell your accountability partner, set up an automatic contribution… whatever it takes, get your Nikes on and just do it.
If you want to get really clever, why not use LSI for your IRA and DCA for your spouse’s? It’ll create a novel experiment for the year and may help convince you of your preferred method in future years.
If you like the idea of LSI, but don’t necessarily have $6,500 laying around on January 1st each year, sock away cash as best you can and then knock it out as soon as your ring the bell on your $6,500 savings goal.
Cleared to Rejoin
The worst time to fund your IRA is never, and the best time is the time you’ll reliably do it. The IRS updates the rules on us from time to time, but it’s up to us to know our tendencies. The math of DCA vs. LSI is interesting, but what you do each year is relevant. It’s February now. What’s your IRA plan for this year?
Fight’s On!
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