It's been 36 years since Congress authorized the IRA — the tax-advantaged Individual Retirement Account. Since then IRA regulations have changed numerous times, and other types of tax-favored retirement plans have come on the scene. With the April 15 deadline approaching for tax-year 2009 IRA contributions, it seems like a good time to answer common questions related to IRAs, such as: "Should I choose a regular IRA or a Roth IRA?"; "Is it worth converting a regular IRA to a Roth?"; "Which is better: IRA or a 401(k)?"; and "How do I roll an old 401(k) into an IRA?"

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The retirement income of most Americans rests on what's been referred to as a "three-legged stool." Retirement benefits from Social Security serve as one of the three legs, of course. But the long-term funding issues facing the nation's Social Security program (relatively fewer workers paying in, more beneficiaries taking out) make it impossible to project with confidence the level of benefits that will be available 20 years or more into the future.

While Social Security has historically provided 35%-45% of retirees' monthly income, younger workers increasingly are skeptical regarding the level of benefits that will be available when they retire.

The second leg of the retirement-income stool is composed of employer-sponsored retirement plans. These plans provide about 15%-20% of current retirees' monthly income on average and fall into two main types.

Some are traditional "defined-benefit plans," in which workers are guaranteed a certain monthly income when they retire; most are newer "defined-contribution plans" — such as 401(k) plans — in which workers have control over investment decisions within the universe of options chosen by the employer. (The value of a defined-contribution account at retirement cannot be known in advance, therefore the amount of money that will be available for a worker's monthly income during retirement is uncertain.) Because workers tend to change jobs more frequently than in the past, relatively few workers will stay in the same employer-sponsored plan all the way to retirement.

The third leg of the retirement-income stool is simply personal savings. It is this leg over which individuals have the most control, and — given Social Security's long-range uncertainties and the fact that 401(k)-type accounts are connected to specific and continuing employment — personal savings are likely to play an increasingly important role in providing adequate retirement incomes in the years ahead.

A key vehicle for building personal retirement savings is the tax-favored Individual Retirement Account (IRA).

Background

The "traditional" or "deductible" 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 returns. Not only did IRA investors enjoy immediate tax-savings, they also were excused from paying any current income taxes on the investment profits they made. Until they began withdrawing the money during retirement, they had the pleasure of watching their money grow tax-deferred.

The IRA deduction was second only to the deductibility of home-mortgage interest as the best tax break available to middle-class taxpayers. Or, more accurately, it was a great tax break for a small percentage of middle-class taxpayers.

As noted, the law made IRAs off-limits to those who already had access to a work-related retirement plan. In 1980, six years after IRAs were introduced, only 2.6 million federal tax returns — out of 93.2 million filed — included deductions for IRA contributions.

So in 1981 Congress liberalized the law, making deductible IRAs available to all wage earners, whether or not they participated in a retirement plan at work. It was then that the IRA concept really took off. By 1985, the number of tax returns claiming an IRA deduction had soared to 16.2 million.

Congress soon decided it had been too generous in allowing a deduction for such a broad swath of taxpayers. So in 1986, the IRA law was changed again, putting new restrictions on who could claim the deduction for IRA contributions. The change eliminated the IRA deduction for wealthier taxpayers (i.e., those whose adjusted gross incomes exceeded specified levels).

But Congress did make an exception — one that harkened back to the original 1974 restrictions: Wealthy taxpayers who were not active participants in an employer-sponsored retirement plan could still make fully deductible contributions to an IRA.

Not surprisingly, the 1986 changes — with new restrictions and thresholds — left many taxpayers confused concerning the deductibility of IRA contributions. The result was predictable: the use of IRAs plummeted. By 1994, only 4.3 million returns reflected IRA contributions — a drop of almost 75% from 1985. But even more complexity was on the way.

In 1997, Congress authorized the "Roth IRA." This new option (named after the senator who sponsored the bill) was an effort to reinvigorate the IRA concept and encourage middle-income folks to save more for their retirement.

The Roth, which remains essentially the same now as when introduced, differs from the traditional IRA primarily in the way taxes are handled: Do you want to pay them now or pay them later?

With a deductible IRA, you can take an immediate tax deduction for the amount you contribute (i.e., you save on taxes now). When the money is withdrawn down the road, that's when you pay the income tax — on both contributions and gains.

With a Roth IRA, on the other hand, contributions are not deductible (i.e., no up-front tax savings ) but all of your future withdrawals, including your investment gains, are tax-free. In other words, there are no taxes to pay later, ever.

Following its earlier pattern with the traditional IRA, Congress set boundaries on who qualifies for a Roth and who doesn't. We'll discuss those boundaries shortly.

IRA ground rules

Although traditional (deductible) IRAs and Roth IRAs received different tax treatment, certain ground rules apply to both types of accounts.

One is that total contributions are limited to a certain amount per year. For the 2010 tax year, total IRA contributions are capped at $5,000 per person, unless you are at least 50 years old, in which case you're allowed to contribute $6,000. Contributions may be split between a traditional IRA and a Roth IRA, but your overall contributions may not exceed the limit.

Stay-at-home spouses often wonder about their IRA eligibility. As long as a husband and wife file a joint tax return, they can make contributions for both the "working" spouse and the "non-working" spouse (not our choice of terms, we assure you!), providing that their combined earned income is at least as large as the IRA contributions made. It doesn't matter how much each spouse earned, or even if one didn't earn any income at all.

So, for 2010, a married couple younger than age 50 could contribute a maximum of $10,000 ($5,000 for each) as long as their overall earnings were at least $10,000 during the year. The contributions must be made to separate IRA accounts, however (there's no such thing as a "joint" IRA).

How should you invest the money you put in an IRA?

A key point: 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 can hold: stocks, bonds, mutual funds, bank CDs — even gold. This means you can invest your IRA money along the same lines as the rest of your long-term investment strategy, whether that involves SMI's Just-the-Basics approach, Fund Upgrading, or one or more of our Advanced Strategies.

Whatever investments you choose, here are a few 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) (or a similar-type plan) at work and your contributions are matched by your employer, don't even consider an IRA until you are contributing enough money to your work-based plan to get the full amount of the employer match. In other words, you want to initially channel your retirement-funding efforts into taking full advantage of the employer-matching opportunity.

Above the matching level, however, it often makes more sense to contribute to an IRA rather than continuing to save within the 401(k). This is because of the flexibility of investing choices available in IRAs. Many employer-sponsored plans have only a handful of investment options from which to choose. That restricts your ability to create the kind of portfolio you'd like to have. With an IRA, on the other hand, the options are wide open.

Still, it almost always pays to get the "free money" of your 401(k) match first.

Eligibilty restrictions

Your income level likely will determine your best option for the type of IRA you choose. Look at the table on below to see which of the five income groups you belong to (be sure to read the small print, especially Footnote 2).

Table

Now consider the following general guidelines:

  • Group 1: If you are in this group, you have the greatest flexibility when it comes to making an IRA choice. You can choose to make either a fully deductible contribution to a traditional IRA or a non-deductible contribution to a Roth IRA. (We'll have a "Traditional versus Roth" discussion in a moment 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 married-filing-jointly income1 is more than $89,000 but less than $109,000, 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. (Group 2 people will also want to pay attention during the "Traditional versus Roth" discussion.)
  • Group 3: You're over the limit. Because your family income is $109,000 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, a Roth is 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. 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 non-deductible contributions to a traditional IRA, then convert those holdings to a Roth. (A law that took effect this year allows such conversions, regardless of income level.) Why bother? Because moving your holdings from a traditional IRA to a Roth would enable you to enjoy tax-free withdrawals of your investment gains when you retire (rather than paying deferred tax on those gains as you would when making withdrawals from a traditional IRA).

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 we just said, you're entitled to a full tax deduction for any contributions you make to a traditional IRA (unless you lived with or filed 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 your modified AGI). And unless you're in Group 5, a Roth IRA is also an option.

Traditional IRA or a Roth?

Now that we've covered the "who qualifies for what?" issue, let's look at three questions that will help you decide what's best when choosing between a Roth and a traditional (deductible) IRA.

Question #1: Can you afford to contribute the maximum allowable amount to your IRA? If you can, the Roth will likely be your best choice, because it's effectively "bigger" than a traditional IRA.

The reason why is that Roth contributions are made with after-tax dollars. So for someone in the 25% tax bracket, it actually takes $6,667 ($5,000 for the Roth and $1,667 for federal taxes) to fully fund a Roth for 2010. In other words, that person is effectively maximizing $6,667 of income — not just the $5,000 being contributed, as is the case with a traditional IRA. (See page 273 of The Sound Mind Investing Handbook for more on this admittedly tricky concept.)

Question #2: Do you expect to be in a lower tax bracket when you retire than you are now? If so, choose a traditional IRA. You get a tax benefit now while your rates are higher, and pay tax later when your rate is (hopefully) lower. Conversely, if you anticipate a higher bracket in retirement, take your tax lumps now and put the money in a Roth.

Unfortunately, this "future tax rates" question isn't as simple as it may seem. That's because with a traditional IRA, the tax dollars you save now are coming off the "top" of your income, i.e., at your highest marginal tax rate. But when you retire, you may not have much income other than what is being withdrawn from your retirement accounts.

This means that a good deal of the money coming out of your IRA will likely "fill in" the lower tax brackets, being taxed at those lower rates, even if the last dollars you withdraw in any given year are in relatively high brackets (similar, perhaps, to the maximum rate you are paying now).

This is a potentially strong argument for sticking with a traditional IRA if you qualify for deductible contributions. Even if marginal tax rates rise in the future, as many expect, it's possible that for many retirees, their average tax rate in retirement will be lower than their marginal (highest) tax rate now. And that's really the key comparison to make for this particular decision.

The case for sticking with a traditional, deductible, IRA is even stronger if you live in a high-income-tax state. You'll save several extra percent in taxes now (whatever your state tax rate is). At worst, you'll pay a similarly high state tax when you take the money out in retirement. At best, you may escape state tax altogether by retiring in a no-tax state (such as Florida or Texas). Simply living in a low- or no-tax state at some point in the future would allow you to convert to a Roth IRA at a lower overall tax rate.

Question #3: Do you expect to want to postpone withdrawals beyond age 70½, or possibly leave the IRA intact for your heirs? If so, opt for the Roth, which — unlike the traditional IRA — has no mandatory withdrawal requirements, ever.

Other considerations

One additional drawback of a traditional IRA is that it can have the effect of turning capital gains (currently taxed at a lesser rate) into ordinary income (taxed at a higher rate). That's because, under current law, when you take money out of your IRA, it will all get taxed the same way — as ordinary income — even though a sizable portion of your growth may have come in the form of capital gains.

If your income is still relatively high in retirement, having some of these gains taxed at your maximum regular income-tax rate (potentially as high as 35%) could be painful, given that they might otherwise (i.e., if not in an IRA) qualify for the lower long-term capital gains rate, which is currently just 15%.

Roths have one additional key benefit — they offer more flexibility than traditional IRAs if you face a cash crunch. With a Roth, you can withdraw the principal you've contributed at any time without facing income taxes or penalties (because you already paid the income tax before the money was contributed).

In addition, even investment gains generally can be withdrawn early without penalty (though regular taxes will still apply) if the withdrawal is related to death, disability, high medical expenses, qualified higher education expenses (for you, a spouse, child or grandchild), or even first-time home buyer expenses.

Naturally there are nitty-gritty details to each of these exceptions. You'll have to do some research to find out specifics. But generally you can get away with simply paying income taxes (no penalties) when withdrawing Roth IRA gains for these purposes. With a traditional IRA, on the other hand, if you touch any of your money early, you will pay dearly.

As you can see, there's no one-size-fits-all answer to the Traditional vs. Roth question. Your personal circumstances may tilt the field clearly toward one option or the other. For others, there may not be an obvious "best" choice. Most people will benefit quite a bit from either type, so if you're not sure which is best, pick the one that appeals to you most and get started!

What about converting my traditional IRA to a Roth?

Whether or not to convert a traditional IRA to a Roth is a question that deserves considerable thought. Because of the likelihood that a conversion will affect other aspects of your tax picture, you may want to get professional guidance before making a decision.

Generally speaking, however, 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? Do you expect to have significant other sources of income in retirement, or are you potentially paying tax at a high rate now only to pay tax at lower rates on your future withdrawals? Is postponing withdrawals or being able to pass the account to your heirs important to you?

There are two additional factors to consider. If you convert your IRA, you'll have to pay income tax on: (1) any gains that you have earned up till now, and (2) any deductible contributions you've made over the years. Unless you've made non-deductible contributions at some point (which most people haven't), that means the full amount you're converting will be taxed as regular income.

If you make a conversion in 2010, you have the choice of either paying the tax when you file your 2010 return a year from now, or you can spread the tax bill over two years — 2011 and 2012. The second option sounds better at first, but there's a catch. Any tax paid in 2011 and 2012 will be at the prevailing tax rates for those years (likely to be higher!), rather than at the current 2010 rate.

Is it worth converting? If you have the resources to pay the extra taxes without having to use any of the IRA balance to do so, it may be. But again, because a conversion may affect other aspects of your over tax picture, don't make a decision without considering all the implications.

Unfortunately, the tax code has become so opaque that it usually requires tax software to run "before and after" simulations to establish whether a move like this will trigger any unintended consequences. The higher income might trigger the AMT (Alternative Minimum Tax) or cause you to lose other valuable deductions and credits.

If you do have the cash on hand to pay the taxes, and converting looks appealing 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.

Managing multiple retirement accounts

Most of today's workers hold multiple jobs in the course of their careers. One result is that people often find themselves with multiple 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 Roth IRA you opened last year. Plus your spouse may have a similar assortment of accounts. What to do with them all?

Generally speaking, it makes sense to "roll over" old work-based accounts into IRAs. A rollover (that is the legal term in the tax code) is simply a tax-free distribution of cash or other assets from one retirement program that you then contribute to another retirement program.

The reason you would want to roll money from an old 401(k) into an IRA is that, as noted earlier, your investment choices usually are going to be much broader in an IRA. Besides that, many companies require former employees to move their holdings out of the company plan within a certain period after leaving the company's employ.

The term "rollover" can be a bit confusing because there are actually two types of rollovers. In one, the money you're putting into your new IRA comes from a qualified employer plan such as a 401(k).

For this type of transfer, you should try to coordinate with your old company's HR department and your new IRA custodian. Typically, you create a new IRA account, then fill out paperwork with your ex-employer to have the money transferred. Details may vary, but the big fund companies and financial institutions handle these transactions all the time and can walk you through this normally painless process.

In the second type of rollover, you are simply moving an existing IRA from one company to another. While it's possible to have the old custodian write a check which you then reinvest in a new IRA yourself (within a 60-day deadline), that is not what we recommend. Instead, it's better to have the company you're transferring to handle the process for you. This is called an IRA asset transfer (sometimes called a trustee-to-trustee transfer).

A transfer of funds from your old IRA directly to your new one is not only simpler, it avoids any potential problems associated with missing the 60-day deadline.

If you have multiple IRA accounts, consider combining them into one. By combining accounts, you'll save on annual fees and cut your paperwork. More importantly, you'll have a much easier time managing your investments and tracking their performance.

Conclusion

The next generation of retirees will be strongly reliant on personal savings for retirement income. Individual Retirement Accounts — both traditional and Roth — are extremely helpful tools for building those savings. Maximizing your IRA savings opportunities should be a high financial priority. The combined benefits of tax-advantaged treatment and investment flexibility make IRAs tough to beat. End