Most financial advice says to invest in your IRA as soon as you can afford the contributions. Whether that's a big lump sum on Jan. 1 or a few hundred bucks every month, investing early has its benefits. The more time your money has to compound inside an IRA, the more likely it is to grow. In general, it's very good advice.
But I always wait until I'm compiling my tax return to determine whether I make my contribution to a traditional IRA or a Roth account, so I always make prior-year contributions.
What's a prior-year contribution?
You actually have until your tax deadline to contribute to your IRA for the year. Taxes for 2020 are due on April 15, 2021, so you can contribute to your IRA for 2020 until that date. If making a contribution after Jan. 1 but before the tax-filing deadline, you can elect to make a prior-year contribution.
If you're making contributions early in the year, and you still have room in your prior-year contribution limit, it's always a good idea to make the election for the prior year. You never know when you'll have a sudden windfall and be able to contribute more to your IRA this year than you could before. If you made a current-year contribution, you'd miss out on the opportunity to set aside more money in your retirement accounts.
The decision between a traditional and Roth contribution
The difference between a traditional IRA and a Roth IRA is primarily based on your effective tax rate on the contribution. There are other considerations for some, but for me, it's all about tax rates.
While I have a good idea of what my tax rate will look like each year, I do have a variable income, uncertainty around capital gains, dividends, and interest, and other income that's not fully predictable.
After all my other deductions, my income usually falls on the border of the 12% and 22% tax brackets. That also puts me on the border of the 0% and 15% brackets for long-term capital gains.
I'm also eligible for some tax credits and deductions affected by my adjusted gross income and taxable income. As a result, I prefer to wait for certainty about what my effective tax rate will be on the last few thousand dollars of income for the year.
This isn't just an issue for those with variable income. You never know when you'll have a sudden change in income. Whether it's from a big bonus at work, unexpected layoffs, or a large capital gain, there's a good amount of uncertainty for most people. If you're torn between a traditional and Roth contribution, it may make sense to wait to determine which is best.
Determine how much you're paying in taxes
If you do your own taxes, figuring out the tax rate on your IRA contribution is really easy. You can plug in your planned IRA contribution as a deduction in your 1040 Schedule 1 (line 19) and see how it changes your total tax liability.
For me, the difference on my federal return this year was about 17% of the $6,000 contribution I planned. I believe I'll be able to manage my taxes for a lower effective rate in retirement, so I decided to make a traditional contribution. You may feel otherwise and decide to contribute to a Roth, even if you'll have the same effective tax rate. Everyone will have a different threshold.
This is a good exercise for everyone, regardless of whether you've already made your IRA contribution for the previous year. For one, it gives you a better understanding of how much you're saving on taxes with a traditional IRA or what your tax rate is on a Roth IRA contribution.
Second, it's possible to recharacterize a contribution from traditional to Roth or vice versa if you find the other more favorable. Admittedly, if I were less lazy, I would contribute early and recharacterize if necessary, but I'd rather not bother with it. My opportunity cost is minimized by the fact that I'm always investing excess savings in some brokerage account.
When to follow conventional advice
There are still good reasons to fund your IRA as early as possible too:
- You're reasonably certain you won't qualify for a traditional IRA deduction -- make a Roth contribution early.
- You won't qualify for a Roth -- make a nondeductible traditional contribution and backdoor Roth conversion early.
- You want the benefit of being able to withdraw your contributions early without penalty -- make a Roth contribution early.
- You just want the simplicity of tax-free Roth withdrawals.
- You don't mind going through the process of recharacterizing a contribution.
The sooner you contribute to your IRA, the more time your investments have to grow. Ultimately, consistently investing as early as possible will produce greater returns than waiting until your tax deadline every year. But for those who are deciding between traditional and Roth contributions, the small opportunity cost of waiting may be worth the convenience and certainty in the decision.