Follow these tips to make the most of planning opportunities.
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By Sue Stevens, CFA, CFP, CPA | 09-07-06 | 06:00 AM | Email Article

As more and more companies have eliminated traditional pension plans, individual retirement accounts are increasingly becoming a cornerstone of many workers' retirement plans. So it only makes sense that you take some time to make sure you are taking maximum advantage of these plans. IRA rules can be complex, but don't let that stop you. The rewards are great for those who know how to squeeze every drop of value from their accounts. Follow these strategies and tips to make the most of your IRAs.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

Strategy 1: Start early.
Lots of young people (and sometimes their parents) don't realize they can contribute to an IRA. One reader recently commented that her child couldn't contribute because he didn't have $4,000 in income. You can contribute an amount less than $4,000! For example, if your college-age child had a summer job and earned $1,400, either you or your child can contribute up to $1,400 to either a traditional or Roth IRA. You can contribute the maximum amount earned up to a limit of $4,000 for 2006 ($5,000 if you're over age 50).

Tip: You have until it's time to file your tax return (not including extensions) to contribute to an IRA for the prior year.

Tip: Get your IRA contributions working as soon as possible. Make your 2005 contributions as early in the year as you can. Sooner is better because there will be more time for that money to compound.

Strategy 2: Plan which investments to hold in your IRA.
A number of factors will affect your "asset location" decisions--which assets to hold in your taxable accounts versus tax-sheltered ones like IRAs. Because capital gains rates are relatively low now, you may want to hold appreciating assets, such as stocks, in taxable accounts. Income-generating assets, such as many bonds, may be better held inside your IRA. This rule of thumb won't always hold true, however. If you are young and have a long time until retirement, you'll want growth investments, such as stocks, to fuel appreciating assets inside your IRA. For more on asset location, click here.

Tip: If you plan to hold inflation-linked bonds, hold Treasury Inflation-Protected Securities in your IRA; because of these securities' tax treatment, they're best held in a tax-sheltered vehicle. I-Bonds, on the other hand, can be held in taxable accounts.

Tip: If your portfolio includes assets in a company retirement plan, such as a 401(k), use IRA assets to further diversify your entire portfolio. For example, many times your company retirement plan will have solid investment options for large-cap stocks, intermediate-term bonds, and cash. But you'll need to use your IRA to further diversify into foreign-stock funds, mid- and small-cap stock funds, real estate funds, or other types of bond funds.

Strategy 3: Convert part or all of your traditional IRA to a Roth IRA.
The Roth IRA has one huge advantage over the traditional IRA: You never have to take required minimum distributions (RMDs) at any age. And when you choose to take distributions, they are tax-free. That's because the Roth IRA requires you to pay taxes up front, either when you contribute the money or when you convert from your traditional IRA to a Roth IRA. And the earnings in that Roth IRA continue to grow tax-free for your beneficiaries after your death. Your beneficiaries do have to take RMDs from your Roth IRA after your death, but they can take these distributions slowly over their own life expectancies.

Converting to a Roth isn't a slam-dunk for all investors, though. For starters, you do have to pay taxes sooner rather than later. Further, there is an element of tax risk involved with Roth IRAs--for example, you could decide to convert now based on current tax laws only to discover five years from now that the tax laws change, thereby making your conversion less beneficial. If your adjusted gross income is more than $100,000, you're ineligible to convert. Finally, if you are younger than age 59 1/2, you must pay the tax for a conversion with assets outside of your IRA or you'll get hit with a 10% penalty on top of income taxes.

Thankfully, IRA conversion doesn't have to be an all-or-nothing proposition. If you're eligible, you can convert some of your traditional IRA now and convert even more later, thereby spreading the tax hit over several years.

Tip: Take a look at the top of your tax bracket. Convert just enough of your IRA so that you don't push yourself into the next tax bracket. For example, if you are married filing jointly, the top of the 15% tax bracket is projected to be $61,300 for 2006. If you earned $20,000 and you had another $5,000 in investment income, that would still allow you to convert $36,300 without falling into the 25% tax bracket.

Tip: The Tax Increase Prevention and Reconciliation Act (passed in 2006) eliminates income limits on Roth IRA conversions in 2010 and beyond. Many people have a renewed interest in making nondeductible traditional IRA contributions between now and 2010 with the intention of converting to a Roth at that time.

Tip: The Pension Protection Act passed recently allows you to convert a company retirement plan to a Roth IRA without first rolling it over to a traditional IRA. But this is only effective starting in 2008, and you still must have an adjusted gross income of less than $100,000 to eligible.

Strategy 4: Stretch out your IRA by choosing the right beneficiary option.
One of the biggest benefits of IRAs (and other tax-deferred accounts) is the ability to defer paying taxes until a later date. That allows the full value of your account to compound over time. Many investors choose to keep the tax-deferral advantage going as long as possible. This process is known as "stretching out" the value of your IRA. The longer you can delay paying taxes, the greater the possibility that your IRA will grow to an even higher balance.

Tip: As part of your overall estate planning, you'll need to think about whom you want to name as your beneficiary. Naming a spouse as beneficiary to your IRA allows him or her to roll over your IRA after your death into his or her own IRA and name a new beneficiary. That can be an excellent way of stretching out the number of years over which you can take distributions. In cases where one spouse is considerably younger, it may not make sense to roll over a deceased spouse's IRA. The surviving spouse may have to be able to tap those assets earlier, without penalty, if he or she keeps the IRA in the deceased spouse's name.

Tip: If you can't name a spouse as your IRA beneficiary, name a child or grandchild. If you have multiple beneficiaries (such as several children), consider splitting your IRA into separate accounts, each with one beneficiary. Then, after your death, each beneficiary will be able to stretch out distributions based on his or her own life expectancy. If your children are already taken care of in the rest of your estate plan, consider adding a grandchild as your beneficiary for maximum deferral opportunities.

Tip: Talk to your beneficiaries. Your heirs need to understand the value of deferral and compounding assets over time. A lack of planning on your part can mean that an uneducated heir may unwittingly pull out large distributions (or the entire balance) to spend on today's "wants" rather than tomorrow's "needs."

Tip: Put your beneficiary preferences in writing, send them to the institutions that hold your assets, and keep a copy for yourself. You should also consider enclosing a card for the institution to send back to you to verify it received your instructions.

Strategy 5: Use your RMDs to rebalance.
If you have a traditional IRA, you'll need to take annual distributions once you are 70 1/2 years of age. Use those distributions as part of your rebalancing process.

Once retired, you should have several years' worth of expenses in cash equivalents. Withdraw your living expenses from those reserves. Occasionally you'll need to replenish those accounts. Use your IRA distributions as part of that process.

Tip: Don't forget to take your RMDs. If you fail to take the correct amount, you'll pay a 50% penalty--in addition to ordinary income taxes--on the amount you should have taken. Ouch!

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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