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By Christine Benz | 02-14-11 | 06:00 AM | Email Article

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.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

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. 

Securities mentioned in this article



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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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