It's crunch time. You're down to your final week. You know that opening an IRA is the best way to get your retirement savings back on track. But there's one decision you still have to make: what kind of IRA should you go with?
Whether you pick a traditional or a Roth IRA might not seem like a big deal. But for most people, there is a top choice -- and it's worth the time figuring out which one is right for you.
Step 1: Are you eligible?
For some taxpayers, the choice between opening a traditional or a Roth IRA is easy, because the IRS essentially makes the decision for you. For Roth IRAs, if you're single and make more than $120,000 in adjusted gross income (AGI), you're not allowed to contribute to a Roth at all. The same holds for joint filers with AGI over $177,000.
With traditional IRAs, the issue is more complicated. As long as you have earned income, you can always contribute to a traditional IRA. The question, though, is whether you can deduct your contributions or not. In a nutshell, here's what you have to look at:
- If neither you nor your spouse (if you're married) are covered by a retirement plan at work, then you can always deduct your traditional IRA contribution.
- If you're not covered but your spouse is, then the same $177,000 limit from the Roth discussion above applies. Above that level, you can still contribute, but you can't deduct what you put into an IRA.
- If you do have a retirement plan at work, then the income limits are much lower: $109,000 for joint filers or $66,000 for singles.
In general, if you have to choose between a Roth or a nondeductible traditional IRA, the Roth is the better choice. But if you still have a choice between deducting a traditional IRA contribution or going with the Roth, read on.
Step 2: What's it worth to you?
The next thing to consider is the benefit of each type of IRA. With a traditional IRA, you get a deduction now in exchange for paying tax later. With a Roth, you pay tax now in exchange for avoiding tax later. So the real question is this: do you think you'll pay more in tax now or later? If you'd pay more now, then a traditional IRA is best. If you'd pay more later, then go with the Roth.
Making a reasoned estimate, though, is harder than it sounds. It's hard enough to guess where tax rates will be next year, let alone when you retire 10, 20, or even 30 years from now. In general, though, if you're in a low bracket now, you should strongly consider going with the Roth -- as most agree that rates have nowhere to go but up. If you're in the highest tax brackets now, you're probably better off taking the current deduction, but it's much less clear as rates could go higher still by the time you retire.
Step 3: What do you already have?
In addition to an IRA, many savers also have a 401(k) at their disposal. It may make sense to diversify your tax exposure in retirement.
So if you have a traditional 401(k), then opening a Roth IRA will help you shelter at least some of your assets from taxation after you retire. But if you have a Roth 401(k) account at work, the immediate deduction you get from contributing to a traditional IRA may be more valuable. At first, only early adopting companies like Microsoft (Nasdaq: MSFT ) , Google (Nasdaq: GOOG ) , and GM offered Roth 401(k)s. But now, nearly 30% of employers now offer both regular and Roth 401(k)s, including stalwarts like IBM (NYSE: IBM ) , JPMorgan Chase (NYSE: JPM ) , and Verizon (NYSE: VZ ) . More employers say they're likely to follow suit by adding Roth 401(k) options this year.
Step 4: How will you invest?
Finally, how you plan to invest makes a difference to which IRA is best for you. If you expect to hit for the fences with small-cap growth prospects like Dynamic Materials (Nasdaq: BOOM ) , then the Roth's tax-free treatment will benefit you best.
For more conservative investors, though, either IRA can help cut taxes. Even if you don't expect much growth from them, high-yield investments like HCP (NYSE: HCP ) benefit from the yearly protection of their dividends from taxation.
Opening an IRA is a smart move. Making the right choice between a Roth and a traditional IRA, though, is even smarter. Even though time is short to make a contribution for the 2009 tax year, it's worth the effort to figure out the best type of IRA for you.
Get the help you need to open an IRA quickly by consulting the Fool's IRA Center.