The Top 10 IRA Mistakes Fighter Pilots Make
Just because you walk on water on your way to work and slip the surly bonds while supporting and defending the constitution doesn’t mean you’re immune to gaffs with your Individual Retirement Account (IRA). If you can fog a mirror, you’ve probably made one or more of these mistakes. No time like the present to find your DFP (debrief focus point) and the IFs (instructional fixes) to max perform your IRA!
IRA 101
While there are approximately 31.6979358533 internets full of information about IRAs out there, here’s the quick refresh you’ll want prior to reviewing the top 10 IRA mistakes.
An IRA is a tax-advantaged account that you establish with an investment institution (bank, brokerage, etc.) to save money. Most save money for consumption after flipping the paycheck switch to O-F-F mode, but IRAs can be an estate planning tool too.
The IRS sets annual maximum limits that you can contribute, currently $6,000 per person under age 50 and $7,000 over age 50. There are two basic types of IRAs: Traditional and Roth.
A Traditional IRA is often called a pre-tax IRA. You skip paying taxes in the year you contribute. The money grows tax-deferred until you access it. You pay taxes at whatever rate is in effect when you access the money, typically after age 59 ½.
A Roth IRA is often called an after-tax IRA. You pay tax at your current rate in the year you contribute. The money grows tax-free until you access it. You pay no taxes when you access the money, typically after age 59 ½.
Both types of IRAs come with a lot of easy-to-manage rules to preserve and enjoy the tax advantages. The key rules are:
Wait until age 59 ½ to begin accessing the money—Tax Uncle is trying to prevent indigent senior citizens from being a social safety net burden, not hook you up as you save for a Tesla in your 40’s.
Early distributions may be available for first-time home purchases, higher education costs, and medical costs, but they’re still taxed. They typically avoid a 10% penalty tax.
(Traditional only) Beginning at age 72, you must start to deplete the account and begin paying taxes on the principal and earnings by taking Required Minimum Distributions (RMD). RMDs are key reason why seniors and widow(er)s have unexpectedly high tax bills.
(Roth only) Roth accounts have several 5-year rules and the main one is that you must wait 5 years after first opening the account to take anything but contributions out lest you pay taxes that were otherwise avoidable.
This list is wildly inadequate to navigate the entire IRA minefield, but if you’re still in your accumulation years socking away money for a home in The Villages, these rules will get you started. See Investopedia or the IRS for more information.
The Top 10 IRA Mistakes (and how to fix them)
- Underfunding. Every January 1st starts open season on building the wealth you’ll want in the future. Every April 15th closes the season. You get 15 ½ months to scrounge up $6,000 each for you and your spouse. Whatever the limit is each year, your future self wants you to shack the target. Future self can’t travel back in time to achieve the annual limit, and one day you’ll be future self, wishing you hit that limit every year.
Fix: Plan to know and hit the limit each year by December of the previous year.
- Overfunding. If you accidentally contribute more than the annual limit, Aunt IRS charges a 6% tax on the excess EVERY YEAR until it’s removed. What’s more, you’ll pay a penalty tax when removing the growth associated with the excess contribution. These taxes are equivalent to leaving a tip for the IRS. Don’t be that guy!
Fix: As soon as you realize the mistake, contact your IRA custodian, your financial planner, or your tax advisor. This goes better with professional help. Don’t delay.
- No Spousal IRA. If you’re married, you can contribute to an IRA for your spouse regardless of his/her working status. This means you need to plan your cashflow to stash $1,000 per month into your IRAs each year (in 2022 dollars). IRAs must be in the individual’s name, one spouse can’t “own” both for the couple.
Fix: Put your budgeting hat on and make sure you’re maxing out IRAs for each of you each year.
- Exceeding the Traditional IRA Income Limit. If your modified adjusted gross income is over the annual limit (which changes each year for inflation), you can’t deduct your Traditional IRA contribution. Standby complexity…
- Whether or not your employer offers a retirement plan affects the income limit for deducting an IRA.
- If only one spouse has a work-based retirement plan, the other spouse has a higher income limit to deduct a Traditional IRA contribution.
- Even if you earn more than the limit, you can make a non-deductible Traditional IRA contribution. More on this in a minute…
If you contributed when you exceed the income limit, you committed mistake #9 above.
Fix: As soon as you realize the mistake, contact your IRA custodian, your financial planner, or your tax advisor. This goes better with professional help. Don’t delay.
- Exceeding the Roth IRA Income Limit. Roth IRAs have income limits too, but they’re higher than the Traditional IRA. I.e., Tax Uncle wants your money now, not later, if you’re a higher earner. Roth IRAs do not have the employer plan rules to contend with.
If you contributed when you exceed the income limit, you committed mistake #9 above.
Fix: As soon as you realize the mistake, contact your IRA custodian, your financial planner, or your tax advisor. This goes better with professional help. Don’t delay.
- Confusing Roth IRA limits with TSP Limits. This one is all too common. Your family income puts you above the limit for a “front door” Roth IRA contribution, so you assume you can’t contribute to the Roth TSP too. Fortunately, they’re not tied together. You can contribute to your Roth or Traditional TSP regardless of what you did (or didn’t do) with an IRA each year.
Fix: This one’s easy. Start contributing to both!
- Skipping a Backdoor Roth IRA. When you make too much to contribute to a Roth IRA ($214K, married filing joint in 2022), you may still be able to contribute to a Backdoor Roth IRA. I’ve written about this extensively so I won’t rehash all of the Backdoor Roth IRA TTPs here. It suffices to say that the Backdoor Roth IRA allows you to legally get around the Roth IRA income limits and still get the amazing benefits of a Roth IRA.
Fix: The rules are complicated, but not complex. Talk to a professional if you need assistance, but don’t skip an IRA contribution each year just because a Backdoor Roth IRA takes a few extra steps.
- Skipping a Non-deductible IRA. If you have a large Traditional IRA, you may not be able to do a Backdoor Roth IRA. But you can still get tax-deferred growth from an IRA contribution even if you don’t get to deduct the contribution when you make it. It most cases, the benefit of the tax-deferred growth will make it worthwhile to stash that money in a Non-deductible IRA.
Fix: Assuming you’d like to invest that annual $6,000 to $7,000, it’s worth working with a professional to determine if you’re likely to be better off putting the money in a non-deductible IRA or taxable account. The answer is probably a bit more involved than just an estimate of your future income tax bracket.
- Too much diversification. Diversification is good. It’s the principle that you don’t put all your eggs in one basket in case the basket breaks. Diversification with investments usually results in harvesting the gains from asset classes that are temporarily over-performing to buy shares of asset classes that are temporarily underperforming.
A multi-asset class fund like a target-date retirement fund might get the job done with a single fund. Otherwise, a single fund per major asset class is often enough diversification without creating an unmanageable, unrebalance-able mess.
Try this sentence on for size: “I own this fund because it should do ____ for my portfolio.” Be ruthless.
The great thing about an IRA is that you can exchange funds at anytime without a tax consequence. If you own 20 funds when 8 to 10 will do, you can thin the herd without a love letter from the IRS.
Fix: You don’t need a professional to help you determine a sound asset allocation and the funds that should go in it, but that’s certainly an option. DIY investors should avoid fads and promises to beat the market. A great place to start reading is here.
- Too little diversification. Often our IRAs become a collection of previously en vogue stocks and funds. The FAANG (now MAANG or MAAAN depending on how persnickety you like to be about acronyms) stocks and various S&P 500 and NASDAQ funds are the usual suspects.
Skipping the benefits of diversification means trying to find the needle in the haystack—the one investment that will pay off in such grand fashion as to vindicate the risk that the one investment might shrink to zero.
As Jack Bogle said, don’t try to find the needle in the haystack—buy the whole haystack. IRAs are meant to keep you from squalid living conditions as a senior—they should be taken seriously.
Longshot bets on speculative stocks and funds might be appropriate for a small portion of a portfolio but google Enron or WorldCom if you need a reminder that even sure things aren’t always.
As mentioned above, the great thing about an IRA is you can reconfigure your investments at will and Tax Uncle won’t send you a bill.
Fix: You don’t need a professional to help you determine a sound asset allocation and the funds that should go in it, but that’s certainly an option. DIY investors should avoid fads and promises to beat the market. A great place to start reading is here.
Honorable Mention
Top thirteen and seventeen lists don’t sound so catchy, but these other IRA mistakes merit a low pass:
No Roth IRA for a working child. If your kids babysit, mow lawns, walk dogs, or have a W-2 job slinging burgers, they’re eligible to contribute to a Roth IRA. I’ll go out on a limb and wager that they won’t do it themselves. If you do it for them, they may not live in your basement one day…
Fix: If you’ve got the extra scratch, you can make the contribution for them so that they can keep their earnings. They just must have earnings. And you need to file a tax return for them!
IRA Annuity. Most readers of this article aren’t at the phase of life where an annuity is an appropriate investment. That won’t stop insurance companies from selling them to you. If you have an underperforming annuity soaking up space in your IRA, you’ve got some work to do to wiggle out of it, but the juice may be worth the squeeze.
Fix: This is another sticky one that might warrant professional help. You’ll need to surrender the annuity; keep the funds inside an IRA (probably rolling them over to another account/institution), and then invest them per your desired asset allocation. Depending on the terms of the annuity, there may be a surrender charge, or a need to wait until it expires.
Traditional IRA when Under the Roth IRA Limits. The choice of Roth or Traditional is about lowering both your current tax bill and your lifetime tax bill. If you’re still on active duty, there’s a host of reasons why you’ll probably have a higher tax bill later in life. If that’s the case, choosing a Traditional IRA when a Roth IRA is available could be leaving the IRS a tip…potentially a six-figure tip.
Fix: It’s possible that a Traditional IRA is your best choice, but without a method of conducting detailed and comprehensive tax projections over each year of your life, you’re flying a bit blind. At a minimum, you need to estimate your tax bracket this year and in your retirement years. If you’re convinced you’ll be in a lower tax bracket decades from now, Traditional can make sense. Otherwise, you might consider betting that your future self would like a pile of tax-free dollars to use while sending less cash to the IRS each year.
Cleared to Rejoin
The best time to plant a tree was 20 years ago. The second-best time is today. The best time to fix IRA mistakes was before your first contribution. The second-best time to fix them is today. If you’re alive and reading this, you’ve probably made some of these IRA mistakes. That makes you normal. But if you can still fog a mirror, there’s time start fixing them. Why not start today?
Fight’s On!
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