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Don’t Wait Until Tax Day to Fund Your IRA

Wind up your 2021 tax year before April 18.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Well, it's tax season, and the tax-filing deadline, April 18, is also the deadline for making IRA contributions if you want them to count toward tax-year 2021. Joining me today with some tax tips and IRA strategies is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.

Nice to see you, Christine.

Christine Benz: Good to see you, too, Susan.

Dziubinski: Let's start by talking a little bit about this April 18 pressing deadline for IRA contributions if you want them to count for 2021. What are some things that investors, IRA investors specifically, should be thinking about right now?

Benz: Well, one of the key things is: Don't wait until the last minute to fund these IRAs. When we talk to investment providers, they have observed that that's a pattern--where investors do rush their contributions in at the very last minute. Ideally, if you can fund your IRAs as early as you possibly can and get that money invested, that gives the money more time to compound. So, that's something to keep in mind. And it's especially important for younger investors because, over time, the combination of either not making the contribution or not actually getting the money invested in something can drag on the portfolio's long-term returns. So, the idea is, hit it as soon as you possibly can. And so, for 2022, for example, we're able to make those contributions for the 2022 tax year starting Jan. 1. So, hit it as soon as you possibly can.

Dziubinski: Do you think analysis paralysis is part of the problem there? How should people really think about what they specifically should be investing those IRA assets in?

Benz: I think analysis paralysis is absolutely the reason why once people fund an IRA, they tend not to get it invested in anything. They just don't know where to start. So, I would say that there are a couple of easy avenues for people figuring out what to put in their IRA. One would be to use a really good low-cost all-in-one fund. So, you could use a target-date fund in this context. You could use a static allocation fund in this context, like one of the Vanguard LifeStrategy funds, for example. So, you could go that route where you're just making ongoing contributions and you're not worrying too much about the complexion of that portfolio because it's internally diversified.

Another avenue that you could head down is to take a look at your portfolio's current exposures. You could use our X-Ray functionality on Morningstar to get a sense of where you need to top up your portfolio's exposures. So, just an example from my own life--my husband and I looked at our portfolio several years ago when we were making our IRA contributions. We identified that we were light on foreign stocks and we were light on value. So, we found a good foreign value fund that helped give us exposure to both areas in one fell swoop, and then we've been continuing to add to our exposure there. So, those, I would say, would be the key ways I would go about figuring out where to invest my IRA funds.

Dziubinski: Christine, speaking of IRAs, I wanted to get a little update from you on the backdoor strategy. Is this still a viable option for investors? There had been talk in Congress about closing this loophole, but it hasn't been closed yet. Is that right?

Benz: That's right. So, just to back up and give people a little bit of background on this backdoor Roth IRA maneuver: Basically, it's a mechanism that allows people who earn too much to make a direct Roth IRA contribution to get money into a Roth IRA. And the basic tool that you use is that you fund a traditional IRA and then you convert that to a Roth later on. There aren't any income limits on those conversions. And so, it's a strategy that higher-income folks have been taking advantage of for the past several years--really since 2010. But there had been some concern that Build Back Better was going to make it impossible to do these conversions of aftertax dollars. Build Back Better hasn't yet passed, so, for now, it's a perfectly allowable maneuver. Higher-income folks should definitely look at it. I would say get some tax advice, though, because one thing that can come into play is what's called the pro rata rule. And I won't go too in the weeds on that, but this is something that can come into play for someone who has a lot of rollover IRA assets, for example. It might cause the backdoor IRA to be taxable when you do that conversion. So, get some tax advice before proceeding. But for now, yes, perfectly legal and allowable.

Dziubinski: Is there a risk that if Congress does in fact close the loophole and Congress makes it retroactive that contributors would have to sort of roll back those conversions or pay back those conversions?

Benz: Well, that has been a worry, I think, for some people who had been funding IRAs through the backdoor--that this would somehow be retroactive if Congress does indeed pass this act. I think from the tax specialists who I've been talking to recently that as we get further into the year that starts to look like a more and more distant possibility, that it looks less likely, I should say. So, for now, I think that it's probably something to keep in your mind as potentially a risk factor, but it's likely to be extremely unpopular among taxpayers as well as financial institutions. And our colleague Aron Szapiro, who does policy research for us at Morningstar, has indicated that it might actually entail some costs on the part of the government, which is not the goal of closing this loophole. So, it seems like a very unlikely prospect.

Dziubinski: We've seen some market volatility so far this year. Are there any tax-saving strategies that we should be thinking about in a volatile market like we're experiencing?

Benz: Well, one of the key ones I would point people to, especially if they've made new purchases, would be to take a look at tax-loss selling, that that's potentially a way to find a silver lining in a rough market environment. If you have holdings that are now trading well below what you paid for them, you can sell them, realize the tax loss, and use that tax loss to offset capital gains elsewhere in your portfolio. If you've exhausted all of your capital gains, you can use the tax loss to offset up to $3,000 in ordinary income. So, tax-loss selling is certainly an idea. It probably will be most effective for people who have brand-new positions in their portfolio or relatively new positions.

Another strategy that can come into play might be Roth conversions. So, the taxes that you will owe when you convert assets from traditional to Roth will depend on the account value. And when accounts have come down a little bit, those conversions will tend to be more attractive. But here's a spot where people should definitely get some tax advice before converting. It can often make sense to make a series of conversions over a series of years. So, a tax advisor or a financial advisor can help you figure out how much you might be able to convert without pushing yourself into a higher income tax bracket.

Dziubinski: Christine, thank you for your time today, walking us through some of these tax strategies. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.