Beth Pinsker: Making last-minute IRA contributions may cost a little you a ‘procrastination penalty’
It’s logical to assume that making a contribution to an IRA account means you’re automatically investing for the future. But there’s a little quirk that could make a huge difference to the millions of people who are rushing to make contributions before the tax filing deadline: If you don’t specify what you want to happen with the money in an IRA—whether it’s a rollover account, a traditional IRA or a Roth IRA—it will just sit there in cash, much like if you had simply made a savings account deposit.
How many people fall into this category? Fidelity, which is one of the largest retirement account custodians, estimates that 40% of those with an IRA of some kind don’t take the extra steps to actively invest the funds.
“People think IRAs work like 401(k)s and it’s invested for you, even if you never make a choice, but IRAs are individual, and it’ll go into cash,” says Rita Assaf, vice president of retirement and college products for Fidelity. “Most people don’t realize it until after a year or two. It catches up as people see their performance.”
Some never realize it though, and it might only come to light after a lifetime of savings is inherited by a spouse or other family and the balance is sharply lower than they were expecting because inflation has eaten away at the meager compounded growth.
And sometimes people know that they need to invest the money, and intend to do it, but never get around to it or the magical “right time” never comes about. “Some of it is purposeful, but then decision paralysis sets in. It’s 100% an issue,” says Jamie Hopkins, managing partner of wealth solutions at Carson Group.
What’s so wrong with cash right now?
You might think, OK, at least today, my cash will be earning a decent amount of interest, and maybe given the market volatility, 3% or 4% doesn’t sound so bad.
But with an IRA, you also have to make some moves to get your cash into a money-market fund that’s earning the highest interest available, because the deposit sweep account or default core cash fund at your financial institution might offer a lot less than you’d expect. This amount will be different everywhere, as will the method for resetting the default. But the difference could easily be more than 1% of interest, which would have a huge impact over time.
“That’s on you as a consumer. Institutions aren’t doing that for you,” says Hopkins.
The financial institution should make it easier for the consumer to make their choices, says Hopkins, especially at the time they’re depositing the money in the first place. “There’s a little bit of an aspect that they don’t want your money out of the money market, they do well with those accounts,” says Hopkins. “But we need to see more reminders that you made your contribution, and now you need to make investment choices.”
Another important component is helping consumers make good investment choices that match up with their goals and risk capacity. Most retirement account custodians will offer levels of service. Some advice and research will be free and available online, and some will require paying a fee.
“You can call, and we can help talk through options, or set up time with an adviser,” says Assaf. “It depends how much skill and time you are willing to put into it.”
Maximize your timing
Vanguard, another of the largest retirement fund custodians, is trying to encourage people to make IRA contributions earlier or do them methodically over time instead of in a lump sum right up against the tax deadline. For the tax year 2022, for instance, you could have made a traditional IRA or Roth contribution at any point, and can continue to do so all the way up to your federal tax filing deadline, which for most people is April 18, 2023.
“Over the past couple of years, we’ve seen more individuals making contributions at the first opportunity in January of the tax year, rather than the tax deadline in April of the following year,” says Maria Bruno, head of U.S. wealth planning research at Vanguard.
In 2021, about 20% of clients made IRA contributions in the first January of the tax year, compared with around 12% in 2019, according to Vanguard analysis. But still, the majority of contributions came in a surge leading up to the April tax deadline 16 months later.
What difference does the timing make? In terms of growth, Vanguard calculates that the “procrastination penalty” of making a later $6,500 contribution in 2023 is about $40,000 over 30 years, assuming a 6% average return.
Another positive trend Bruno is seeing at Vanguard is that 9 out of 10 contribution dollars are going into Roth accounts, especially among younger participants. You make a Roth IRA contribution with posttax dollars and the growth accumulates tax-free. “That investor is much more proactive in terms of understanding the tax advantages,” says Bruno.