Roth Rules for Retirees: Earn with Early Contributions


It’s usually nice to have a grace period, a little extra time to pay a bill. But IRA investors who rely on the government’s generous deadline for annual contributions are usually hurting themselves, not Uncle Sam.

Contributions for 2009, for example, could have been made as early as Friday, Jan. 2, 2009, assuming your broker, bank or fund company was closed New Year’s Day. But you have until April 15 of this year to make the 2009 contribution, unless you file your tax return earlier, which makes the filing date the deadline.

Sure, waiting gives you lots of flexibility, and more time to scrape the money together. But waiting until the last minute also means missing out on 15 months of tax-sheltered growth.

What would that cost? It depends, of course, on your potential investment returns. And if the markets are sinking, postponing a contribution could allow you to invest at bargain prices, boosting your returns.

But most IRA investors are not trying to time the market, or are not very good at it if they do try. IRAs are long-term investments generally made with a certain faith that the markets will rise over time. Since markets generally do go up over time, delaying a contribution means missing out on potential gains in the average year.

Hilliard Lyons, a Louisville, Ky., wealth management firm, analyzed the cost of delaying a $5,000 IRA contribution for 2009. Assuming an investment return of 8% a year, this investment would earn $520 from Jan. 2, 2009 to April 15, 2010.

Those gains would be tax-free in a Roth IRA. In a traditional IRA, the gains would be taxed as income upon withdrawal. But that could be many years off, perhaps decades.

If the investor kept the $5,000 in an ordinary taxable account with the same 8% return until April 15, 2010, the $520 in gains would be trimmed to $312, assuming a combined federal and state tax bracket of 40%.

Of course, the cost of delay is much more severe if you do it every year. Hilliard Lyons figures an investor who made IRA contributions at the start of each year would have $10,000 more after 20 years than an otherwise identical investor who waited to the last minute.

What if you make a mistake in contributing to an IRA? That can happen, for example, if you invest in a traditional IRA and later decide you should have chosen a Roth, or vice versa. No problem: you can reverse the mistake through a “recharacterization.” Brokerage firm Charles Schwab (Stock Quote: SCHW) has a good explanation.

Unless you are an adept market timer, investing as early as possible is usually the best policy. That means making your 2009 contribution now, not April 15. And, obviously, it also means making the 2010 contribution as soon as possible.

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