Morningstar's 30-Minute Money Solutions by Christine Benz

Author:Christine Benz
Language: eng
Format: epub
Publisher: Wiley
Published: 2010-05-10T16:00:00+00:00

19

Determine What Type of IRA Is Best for You

AS WITH 401(K)S and other company retirement plans, would-be IRA holders confront a bewildering array of choices, and maybe that helps explain why so few investors fund an IRA on their own. (The vast majority of IRA assets are there because individuals rolled over their company retirement plans after they left their employers.) In addition to deciding what types of investments to put in the IRA (which I discuss in the next chapter), you also have to decide what type of IRA you want to save in. More choice overload.

There are two main IRA types: a traditional IRA and a Roth IRA. 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 that 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. 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. And while the Roth is generally going to be the better option for most investors, it’s not a slam-dunk in every single situation. If your income falls below a certain threshold, you can make at least a partial contribution (and possibly a full one) to a traditional IRA and deduct that contribution from that year’s income tax return. Individuals in higher income tax brackets can also contribute to a traditional IRA, whereas 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 they’ll still enjoy tax-deferred compounding on their money. (And, in 2010, investors at all income levels will be able to convert a traditional IRA into a Roth—an option that was heretofore off-limits for those at higher income levels. If you earn too much to contribute to a Roth, this can be a good way to get into one. I discuss converting an IRA in Chapter 21.)

So, how do you add some rigor to the decision-making process about whether to invest in a Roth or traditional IRA? The following steps will help you decide.

To determine what type of IRA is right for you, you’ll need:• Anticipated income level for the current tax year

• Current income tax rate

• Morningstar’s IRA Calculator (available at www.morningstar.com/goto/30MinuteSolutions)

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