Last-Minute IRA Basics

Ah, my IRA. How do I love thee? Let me count the ways.
I love thee to the depth and breadth and height of thy ... tax-advantaged goodness.

OK, so maybe IRAs aren't exactly the stuff of great poetry. But these great wealth-builders are worthy of celebration, thanks to their tax-advantaged features. And this is the week when IRAs should be in the thoughts of every Fool who hasn't yet opened one or made a contribution for last year. With the 2006 deadline looming -- that's not a typo; the deadline is next Tuesday, April 17 -- it's a good time to review the basics and decide where to send that check.

The basics
IRAs come in several different flavors, but the two most important ones at this time of year are traditional and Roth IRAs. The contribution limits are the same -- $4,000 for 2006, $5,000 if you're 50 or older. The biggest differences between the two are in who's eligible and when you pay taxes. Contributions to a traditional IRA are tax-deductible under some conditions (more on that in a minute), and your earnings grow tax-deferred, meaning you don't have to pay taxes on interest and capital gains, but your withdrawals will be taxed as ordinary income. With a Roth IRA, your contribution isn't tax-deductible, but your earnings are tax-free -- you'll never have to pay taxes on the capital gains and interest you earn from your investments, even when you take withdrawals.

Who's eligible?
Anyone with a job -- or anyone who is married to someone with a job -- can contribute to a traditional IRA, but if you participate in a retirement plan at work, your contribution is tax-deductible only if your income is below certain limits. (For more details, see Fool retirement guru Robert Brokamp's guide to IRAs.)  For a Roth IRA, you can make a full $4,000 contribution if your 2006 income was below $95,000 for singles or $150,000 for married couples filing jointly. If your income was close to these limits but a little higher, you may be able to make a partial contribution -- see the link above or the IRS website for more details.

So which one is better?
It depends. Assuming you're eligible, Roth IRAs have a couple of useful features that make them worth considering. First, you can withdraw your contributions (though not your investment gains) at any time, without a tax penalty. This makes a Roth IRA an appealing place to stash some rainy-day money -- money you don't plan on using until retirement but that is available to you in a true emergency. Second, unlike a traditional IRA, a Roth IRA doesn't require you to start taking distributions at age 70 1/2. That may not seem like a big deal now, but having more flexibility will make developing a withdrawal strategy and estate planning that much easier when the time comes.

The big advantage of the traditional IRA is that upfront tax deduction. If you need it, and you're eligible, take it and don't look back. If you're not sure you really need it, ponder this: Will you be in a lower tax bracket once you're retired? If the answer is a definite yes, then it might make sense for you to take the deduction now. On the other hand, if you're planning to live large during retirement, taking the tax hit now could work out in your favor in the end.

One last thing: If you're married, and you really want to maximize your joint retirement savings, you and your spouse should both make IRA contributions every year. Even if only one of you is employed, you can both make contributions as long as you file a joint tax return -- and the more you save now, the happier you'll be when you're 70.

For more rich and tasty IRA goodness, check out The Motley Fool's comprehensive IRA Center. As you plan your retirement strategy, you should also have a look at the Fool's Rule Your Retirement newsletter and our excellent retirement investing discussion board.

Fool contributor John Rosevear invites you to send him your comments, your questions, and your bad IRA poetry, which he just might include in a future article. The Motley Fool has a disclosure policy.


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