Maximizing Your IRA Opportunities

Your retirement income rests on what has been referred to as a three-legged stool. Social Security has traditionally been regarded as the first of the three legs; however, problems with Social Security make it impossible to project with confidence the level of benefits that will be available twenty years or more into the future. While the program has historically provided 35%-45% of retirees' monthly income, younger workers are increasingly skeptical of what will be available when they retire.

Private employer-sponsored retirement plans are the second leg of the stool, and provide about 15%-20% of current retirees' monthly income on average. But there's a lot of room for variation here. Corporate America has been strongly moving away from defined-benefit plans for many years, so many of today's workers will never see a guaranteed pension.

As a result, it's obvious that the third leg of personal savings and retirement funds will continue to play an increasingly important role in providing adequate retirement incomes. And one of the best ways to go about building your personal retirement funds is by using an Individual Retirement Account (IRA).

What we might call the "Deductible IRA" (or "Traditional IRA") first appeared in 1974 when Congress voted to allow certain working persons—those not covered by a pension plan at work—to put away up to $2,000 a year for retirement and deduct it from their federal income tax return. Not only did they enjoy immediate tax-savings, but they also were excused from paying any income taxes on the investment profits they made. Until they began withdrawing the money upon retirement, they had the pleasure of watching their money grow tax-deferred. Other than the deductibility of home mortgage interest, it was the best tax break available to the middle class.

Not many were able to take advantage of it, however, because IRAs were only available to those who lacked a work-related pension benefit and that was a relatively small percentage of the work force. In 1980, six years after IRAs were first introduced, only 2.6 million federal tax returns included deductions for IRA contributions. So in 1981 Congress liberalized the law, making Deductible IRAs available to all wage earners, regardless of whether they participated in a retirement plan at work. This is when the IRA concept really took off.

By 1985, the number of tax returns claiming an IRA deduction had soared to 16.2 million. Congress, true to form, soon decided it had been too generous in allowing taxpayers to keep so much of their income. In 1986, the law was changed to eliminate the tax deduction on contributions to Deductible IRAs for wealthier taxpayers—namely, those whose adjusted gross incomes exceeded specified levels. There was one exception to this change: Taxpayers who were not active participants in an employer-sponsored retirement plan could still make fully deductible contributions to their IRAs regardless of their level of income.

The new complexity left taxpayers confused concerning the deductibility of their contributions. The result was predictable—the use of IRAs plummeted. In 1987, the first year under the new law, the number of tax returns claiming IRA deductions fell by more than half. By 1994, only 4.3 million returns reflected IRA contributions. And the complexity was just beginning.

The IRA landscape grew even more complicated in 1997 when Congress gave us the "Roth IRA." This new option was an effort to reinvigorate the IRA concept and encourage middle-income folks to save more for their retirement. It differs from the Deductible IRA primarily in the way taxes are handled—do you want to pay them now or pay them later? In a Deductible IRA, you receive a tax deduction for the amount you contribute (save on taxes now) and eventually pay income tax on all contributions and gains when money is taken out down the road (pay taxes later). With a Roth IRA, your current contributions are not deductible at all (no tax savings now) but all of your future withdrawals, even your investment gains, are tax-free (no taxes to pay later, ever).

IRA GROUND RULES

Regardless of what type of IRA is being discussed, certain ground rules apply. First is that your total contributions are limited to a certain amount per year. For the 2006 tax year, your total IRA contributions are limited to $4,000 per person (unless you are at least 50 years old, in which case you're allowed to contribute $5,000 per person). For 2007, the limit remains at $4,000 per year per person, again with an extra $1,000 permitted for those 50+ years old. It's important to note both limits, as tax law allows you to make a 2006 IRA contribution as late as April 15, 2007.

Stay at home spouses often wonder about their IRA eligibility. This is quite simple—as long as you file a joint return, you can make contributions for both the "working" and "non-working" spouse (not our choice of terms, I assure you!), providing your combined earned income is at least as large as the IRA contributions made. It doesn't matter how much each spouse earned, or if one didn't earn any income at all. So for 2006, a married couple younger than age 50 could contribute a maximum of $8,000 as long as they earned at least $8,000. The contributions must be to separate IRA accounts however, as there's no such thing as a "joint" IRA account.

The last ground rule deals with how to invest IRA money. The key is understanding that an IRA is not, in and of itself, an investment. It's merely an "umbrella" that shelters your investments from taxes. So an IRA can hold most of the same investments any other account could hold—stocks, bonds, mutual funds, bank CDs, etc. That means you can invest your IRA money along the same lines as the rest of your long-term investment strategy, whether that involves Just-the-Basics, Upgrading, or some other strategy. There are ways to maximize the tax-deferred advantages of an IRA if you have a mixture of both IRA and taxable accounts—see Keep More of Your IRA/401(k) Through Smart Tax Planning  for details.

WHICH IRA IS RIGHT FOR YOU?

Today's IRA landscape can be split into three main groups. Traditional IRAs come in two flavors—"deductible" if your income is below certain levels, or "non-deductible" if your income is above those limits. Then there's the totally separate class of Roth IRAs. It can be confusing trying to figure out which is type is best for you. But it's worth the effort.

Here are some general principles to help guide your decision as to the best place to invest your retirement money. The first is this: If you participate in a 401(k) where your contributions are matched, and you're currently not contributing up to the full amount that would be matched by your employer, you don't even need to consider IRAs at this point. Channel your efforts into taking full advantage of the employer matching opportunity in your 401(k). Above the matching level, it often makes sense to contribute excess savings to an IRA rather than continuing to save within the 401(k), due to the flexibility of investing choices available in IRAs. But it almost always pays to get the "free money" of your 401(k) match first.

The next principle is that your annual income will likely determine your best IRA choice. Look at the table below to see which of the five groups you belong to. Be sure to read the small print, especially Footnote 2. Now consider the following general guidelines:

• Group 1: You have the greatest flexibility. You can choose to make either a fully deductible contribution to a traditional IRA or a non-deductible contribution to a Roth IRA. In a moment we'll have a "Deductible versus Roth" discussion that will be helpful in making your decision.

• Group 2: You're in the "phase-out range" where the government begins taking away your tax deduction for contributing to a traditional IRA. Because your family income is more than $83,000 but less than $103,000, only a portion of your contribution is tax-deductible. (Single taxpayers have a lower threshold at each step along the way as can be seen in the table.) You'll also want to pay attention during the "Deductible versus Roth" discussion. Note that the IRS uses a very precise definition for "modified adjusted gross income." See Pub 590 at IRS.gov.

• Group 3: You're over the limit. Because your income is $103,000 or more, you receive no deduction—unless you're a Footnote 2 person and have no retirement plan at work. You could make a non-deductible contribution to a traditional IRA, but why do that with the Roth option available? You're Roth material all the way.

• Group 4: Like Group 3, Roths are your best option. But you're in the "phase-out range" where the government begins taking away your right to make a full Roth contribution. Still, take what you can get.

• Group 5: Sorry. You've been too successful and Congress figures you don't need any tax incentives to save for retirement. You're on your own—no IRAs for you. Well, that's not strictly true. You could make a non-deductible contribution to a traditional IRA and, considering your lack of other options, you might want to do just that. At least you get tax-deferred growth on your investments, and you pay taxes only on your investment gains when withdrawals are made, not on the amount of the entire withdrawal. Be careful though—depending on how you plan to invest, a plain old taxable account may be a better choice. For more, see Keep More of Your IRA/401(k) Through Smart Tax Planning  and Roundabout Way to a Roth .

Now, all you Footnote 2 folks who aren't covered by a retirement plan at work, pay attention. You're the exception to the rule. No matter what group you're in and no matter what we just said, you are entitled to a full tax deduction for any contributions you make to a Deductible IRA unless you file jointly with a spouse who is covered by a plan at work. In that case, your deduction may be phased out or eliminated based on a modified AGI in excess of $156,000. And unless you're in Group 5, a Roth IRA is also an option.

DEDUCTIBLE VS. ROTH IRA

Okay, that covers the basic "who qualifies for what?" question. Now let's look at three questions that will help you decide what's best when choosing between a Roth or Deductible IRA.

The first question to consider is: Do you expect to be in a lower tax bracket when you retire than you are now? If so, choose a Deductible IRA. You get a tax benefit now while your rates are higher, and pay tax later when they're lower. Conversely, if you anticipate a higher bracket in retirement, take your tax lumps now and put the money in a Roth. It'll sure feel good coming out tax-free in the future.

Unfortunately, this question is probably useful only if you anticipate retiring and beginning IRA withdrawals within 10-15 years. Beyond that it's too hard to predict what might happen to tax rates, not to mention personal circumstances. However, tax rates are very low by historical standards right now. Plus, the longer your time horizon, the greater the tax-free advantages of the Roth become. In short, if you can't reasonably predict whether your tax rate will be higher or lower in the future than at present, favor the Roth.

The second question is: Would you like to postpone withdrawals beyond age 70½, or possibly leave the IRA intact for your heirs? If so, opt for the Roth, which has no mandatory withdrawal requirements, ever.

The final question is: Can you afford to contribute the maximum allowable amount into a Roth? Remember, those are after-tax dollars. Assuming you're in the 25% tax bracket, it would actually take $5,334 ($4,000 for the Roth and $1,334 for federal taxes) to fully fund a Roth for 2006. If you can do that, you'll almost certainly get a better deal with the Roth, because you're effectively maximizing $5,334 instead of just $4,000 with a traditional IRA. (See Chapter 23 of The Sound Mind Investing Handbook for details.)

To sum up, unless retirement will be arriving shortly and with it the expectation that you'll be in a lower tax bracket, the Roth IRA is the superior choice for most retirement savers.

If you're still considering a Deductible IRA, be sure you take these drawbacks into consideration. It's easy to become so impressed with the power of tax-deferred compounding that we can overlook a few of the disadvantages of the traditional IRA. One is that it turns lower-taxed capital gains into higher-taxed ordinary income. That's because when you begin taking your money back out, it all gets taxed the same way—as ordinary income—even though a sizable portion of your growth came in the form of capital gains. With long-term capital gains currently taxed at just 15%, having these gains taxed at your maximum regular income rate (potentially as high as 35%) can be painful.

Another drawback is the set of rules governing how much you must take out each year beginning at age 70½. If you run afoul of them, the penalties are steep. And a third drawback is the estate tax possibility. Traditional IRAs are typically hit with a combination of income taxes and estate taxes. That can mean 60%-70% going to taxes.

Roth IRAs are better in regard to all three of the above concerns: (1) all monies taken out of a Roth are tax-free; (2) there are no mandatory distribution requirements; and (3) estate taxes still apply but no income taxes or penalties come into play.

Roth's also offer more flexibility than traditional IRAs if you face a cash crunch. In a Roth, you always have access to the principal you've contributed without income taxes or penalties. In addition, earnings can generally be withdrawn early without penalty (though regular taxes will still apply) if the distributions are for death or disability, high medical expenses, qualified higher education expenses for you, a spouse, child or grandchild, or first time home buyer expenses. Naturally there are many details to each of these exceptions, so you'll have to do some research to find out more specifics, but generally you can get away with just paying income taxes and no penalties in these cases. With traditional IRAs, if you touch any of it early, you pay dearly. Roth's can also make an effective college savings tool, if that's a consideration (see Using a Roth IRA To Save for College).

MANAGING MULTIPLE RETIREMENT ACCOUNTS

Today's worker will likely hold several different jobs in the course of their career. That often means people find themselves inadvertantly "collecting" retirement accounts. There's your old 401(k) from Glad-I-Left Corp., the Traditional IRA you opened with your 1999 bonus check, your current company's retirement plan account, and the new Roth IRA you opened last year. Plus your spouse's assortment of accounts. What to do with them all?

Generally speaking, it makes sense to roll over old work accounts into IRAs. Your investment choices are usually going to be much better rather than being limited to the handful of fund options offered in most 401(k)s. This means you'll be able to follow SMI's proven Upgrading strategy. Some experts say it's smart to keep old 401(k) money in one IRA, separate from any IRAs funded with regular contributions. The thinking is that eventually you could roll your rollover IRA back into a 401(k). The main reason for doing that would be so you could borrow from the 401(k), which we discourage. So for simplicity's sake, we'd be inclined to consolidate IRA accounts into as few as possible. But it's up to you whether that slight loss of flexibility is worth keeping multiple IRAs open.

How do you go about rolling over an IRA? First, recognize that there are really two types of rollovers. In one, the money you're putting into your new IRA comes from a qualified employer plan like a 401(k). In this type of transfer, you'll want to coordinate with your old company's HR department and your new IRA custodian. You'll normally create your new IRA account, then fill out paperwork with your ex-employer to have the money transferred. Details may vary, but the big financial institutions handle these transactions all the time and can walk you through this normally painless process.

In the second type of transfer, you're just moving your IRA from one place to another. While it's possible to have the old custodian write you a check and then reinvest the proceeds in the new IRA yourself within sixty days, that is not what we recommend. Instead, have the company your new IRA is with handle the process for you. This is called an IRA asset transfer (sometimes called a trustee-to-trustee transfer). A transfer of funds at your request from your old IRA directly to your new one is not only simpler but it avoids any potential problems associated with missing the sixty-day deadline.

If you have more than one IRA account, consider combining them into one. It's not unusual for people to have many different IRAs spread around various places that were offering the "best deal" at the time their contribution was made. By combining them into one account, you'll save on annual account fees and cut your paperwork. More important, you'll have a much easier time managing your investments and tracking their performance. As always, there's an exception: be sure to keep IRAs of different types separate. Putting an IRA with non-deductible contributions together with one containing deductible contributions is not only confusing, it can cost you down the road if you can't distinguish which withdrawals should and should not be taxed.

Whether or not to convert a Traditional IRA to a Roth is another question that deserves considerable thought. First things first—are you eligible to convert? To be eligible, your "modified adjusted gross income" (not including the converted IRA income) needs to be less than $100,000. If you meet that criteria, some of the questions are the same as the ones we looked at earlier: How does your current tax bracket compare with your anticipated tax bracket in retirement? Is postponing withdrawals and/or being able to pass the account to your heirs important to you?

There are also two additonal factors to consider. If you convert your IRA, you will have to pay income tax on any gains in the account, plus any deductible contributions you've made over the years. Unless you've made non-deductible contributions at some point, that usually means the full amount you're converting will be taxed as regular income on this year's tax return, which can add a sizeable sum to your tax bill. If you have the resources to pay those extra taxes without having to use any of the IRA balance to do so, it may be worth converting. But if you'll have to pull money out of the account just to pay the tax bill, converting is probably not a good move. Not only will you lose out on future appreciation on these funds, but you'll pay a stiff early withdrawal penalty if you're under age 59½.

If you have the cash on hand to pay the tax bill, and converting looks good to you, a final question to consider is how far off is your retirement? At a bare minimum, you should have at least five years before you'll need to tap the converted IRA. That's because you'll face early withdrawal penalties if the Roth is not established for five years before withdrawals begin. A five year horizon is a minimum, not an automatic signal to proceed. The Roth's advantages build with time, so the longer the Roth will be intact, the better your chances that the conversion will be worthwhile.

CONCLUSION

There's no question that America is trending towards a greater reliance on personal savings for meeting retirement income needs. The days of government and employer funded retirement are rapidly drawing to a close. At present, IRAs are one of the most attractive tools available for building the personal savings the next generation of retirees will be reliant upon. Maximizing your IRA savings opportunities, specifically your Roth IRA opportunities if eligible, should be a top financial priority. The combined benefits of tax-advantaged treatment and investment flexibility make IRAs tough to beat.

Hopefully this article has motivated you to take advantage of the tremendous opportunity provided through an IRA. If so, your next step is to determine what investing approach to use. For help with this critical decision, we suggest you examine the primary Investing Strategies offered by Sound Mind Investing. Once you determine your investing approach, you'll be ready to 2008 Broker Review: Choosing the Broker That's Right For You . Then it's just a matter of being faithful to fund your IRA, and watch time and the wonder of compounding work their magic!

• SMI Investing Strategies
• 2008 Broker Review: Choosing the Broker That's Right For You 
• Keep More of Your IRA/401(k) Through Smart Tax Planning 
• Using a Roth IRA To Save for College
• IRA & 401(k) page
• SMI Subscription Information

• Five strategies to maximize your IRA | Morningstar

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