Find the Right IRA in Three Easy Steps

Christine Benz, On Monday February 14, 2011, 7:00 am EST

Investors spend a lot of time focusing on things they can’t control. For instance, they worry about what direction the market is headed, but there’s really no way to know and nothing anyone can do to influence its direction. It’s more productive to instead focus on things you’re truly in control of, such as limiting your investment costs and making sure you’re maximizing all of the tax-advantaged options that are available to you. That means contributing as much as you’re able to your 401(k) and also funding an IRA if you’re eligible.

You have until April 18, 2011–that’s three more days than usual, folks–to make an IRA contribution for the 2010 tax year. If you have some extra cash on hand, why not fund an IRA for 2011, as well? Your money will compound on a tax-free or tax-deferred basis (more on the differences in a second). Unlike a 401(k) or other employee-benefit plan, in which you typically have a fixed menu of choices, your investment options for an IRA are virtually limitless. Also, while investing $5,000 per year (the IRA contribution limit for savers under age 50 in 2010 and 2011) might not sound like a lot, that money can grow to a fairly impressive sum over time. If, starting today, you contributed $5,000 annually to an IRA for the next 20 years and you earned 7% on that money, you’d have more than $200,000 at the end of the period.

Even if you’re already convinced that saving in an IRA is sensible, you still have a little bit of research to do. There are two main types of IRA accounts, and selecting the one that’s best for you can be a daunting process. Fortunately, you can figure this out in relatively short order by following these three steps.

Know the Basics
We’ve already established that both vehicles let you sock away money and enjoy a tax benefit. With a traditional IRA, you won’t have to pay taxes on your IRA’s investment earnings until you begin taking distributions from it during retirement; thus, your money enjoys the benefit of tax-deferred compounding. (That means you’ll have to pay taxes on your earnings when you begin withdrawing money from the kitty, but not as you go along.)

The Roth, however, has a couple of huge advantages over a traditional IRA. Whereas traditional IRAs carry restrictions governing when you have to begin taking distributions, the Roth carries no such restrictions; you won’t be forced to take distributions at any age. That’s great news for savers who may not need to use their IRA assets in retirement; instead, they can let the money compound and grow for their heirs. And perhaps even more significantly, qualified distributions from a Roth will be tax-free, not tax-deferred as is the case with a traditional IRA.

With that information, the choice might seem clear: Roth IRA all the way. But there are a few other issues to consider. First, if your income falls below a certain threshold (in 2010, it was less than $66,000 for individuals who can contribute to a retirement plan at work and less than $109,000 for married couples filing jointly), you can make at least a partial contribution (and possibly a full one) to a traditional IRA and deduct that contribution from your income tax return.

Individuals in higher income tax brackets can also contribute to a traditional IRA, whereas a direct contribution to a Roth might not be available to them because they earn too much. Higher-income savers won’t be able to deduct their contributions on that year’s tax return. But if they stick with the traditional deductible IRA, they’ll be able to enjoy tax-deferred compounding on their money. Better yet, they can immediately convert their contribution to a Roth IRA and enjoy tax-free withdrawals in retirement. This article discusses the ins and outs of this kind of backdoor IRA and also delves into why this maneuver might not make sense for people with a lot of other IRA assets.

Determine Your Eligibility
Okay, you’ve now identified the account type that suits you. You’re done, right? If only it were that simple. But there are certain eligibility hurdles you’ll have to clear in order to use a traditional or a Roth IRA.

Let’s start with the most sweeping limits first. As I noted above, you can’t make a deductible contribution to a traditional IRA if your income comes in above a certain level. And if you’re single (or the head of a household) and earned more than $120,000 in 2010 or part of a married couple who made more than $177,000 last year, you’re not eligible to make a direct contribution to a Roth IRA.

But raw income isn’t the only factor that can affect which type of IRA you might be eligible for; you’ll also have to factor in your tax-filing status and whether you’re eligible to contribute to a company retirement plan. To help simplify the task, I suggest you check out the Morningstar IRA Calculator. Plug in a few of these variables and voila–you can see how much you can contribute to a traditional IRA (deductible and nondeductible contributions) and a Roth IRA each year.

Weigh Your Options
After you’ve input your information into the IRA Calculator, you may find that certain IRA types are automatically off limits to you due to your income level. For example, if you’re in one of the higher tax brackets, you’ll find that you can’t contribute to a Roth; your only IRA option is to make a nondeductible contribution to a traditional IRA. (If you wanted a Roth, you’d have to convert those assets.)

But what if you establish that you’re eligible to make more than one type of IRA contribution– for example, you can contribute to a Roth and make a deductible contribution to a traditional IRA? You may decide to split your contribution between both vehicles, or you could go back to the IRA Calculator for a more definitive answer. Click on the Comparison tab at the top of the calculator, then enter the data you’re asked to provide. (If you’re not sure about your tax rate, refer to the Internal Revenue Service website.)

After you’ve entered all of your information, click Submit. You’ll see a comparison of how a contribution to each of these investment vehicles would have compounded, once tax effects are factored in, by the time you’re ready to retire. We also show you how an investment in a regular old taxable account would fare.

For example, if you’re eligible to make a deductible contribution to a traditional IRA and fund a Roth IRA, you may find that the traditional IRA contribution is your best bet because you’ll be able to contribute that money without having to pay income taxes on it. Similarly, even if you’re not eligible to make a deductible traditional IRA contribution or a Roth IRA contribution, you might find that a nondeductible contribution to a traditional IRA might still make sense for you because you’ll be able to convert that money to a Roth.

In addition to helping you select the right IRA, the IRA Calculator can also help you determine whether to convert any traditional IRA holdings to a Roth IRA in order to enjoy the tax-free compounding that the Roth confers. You’ll pay income tax on any investment earnings or deductible contributions when you convert, but the long-term tax savings of the Roth may offset the short-term tax hit. To use that feature of the tool, click on the Conversion tab of the IRA Calculator.

Once you’ve gone through the process of selecting the right IRA type for you, you’ll need to find the right investment(s) to put in it. (Remember, the IRA is just the “wrapper” for whatever investments you select, and your investment choices are virtually unlimited.) Morningstar’s Fund Analyst Picks and 5-Star Stocks are a great starting point when searching for the right investments for your IRA. (Fund Analyst Picks and Morningstar Ratings for stocks are available to Premium members of Morningstar.com; for a free trial subscription click here.)

A version of this article appeared Jan. 26, 2010.

Morningstar

Leave a Reply