Before you spend all of your windfall this spring, though, I urge you to set aside at least part of your extra cash to fund an IRA. After all, you still have until April 15, 2006, to make any contributions for the 2005 tax year. 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 $4,000 per year (the IRA contribution limit for savers under age 50 in 2005) might not sound like a lot, that money can grow to a fairly impressive sum over time. If, starting today, you contributed $4,000 annually to an IRA for the next 20 years and you earned 7% on that money, you'd have $175,000 at the end of the period.
Even if you're already convinced that saving in an IRA is a sensible thing to do, 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
Understanding the difference between the two types of IRAs--the Roth and the traditional IRA--is the key first step in determining which is suitable for you.
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. 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 2005, it's less than $60,000 for individuals who can contribute to a retirement plan at work and less than $80,000 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 Roth might not be available to them because they earn too much. They 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.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 earn more than $110,000 or part of a married couople wh makes more than $160,000, you're not eligible for 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.
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 do both if you have the money to do so, but if you have a limited sum of money to invest, I'd go back to the IRA Calculator. 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 IRS' Web site
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, on an aftertax basis, 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 enjoy tax-free compounding on your money.
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. 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
are a great starting point when searching for the right investments for your IRA. (Fund Analyst Picks are available to Premium members of Morningstar.com; for a free trial subscription click here
.) But there are also some nuances that might make some investment types more suitable for your IRA than others. We'll cover that topic in next week's column.A version of this article appeared on Morningstar.com on 3/15/05.