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The Key Decision You Must Make This Week

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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.

Choose wisely
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.

Attention, Fools! Looking for a trustworthy financial planner? The Garrett Planning Network is offering a limited-time 10% discount for new Motley Fool clients. Just click this link, search your state, and look for the Motley Fool icon to identify participating advisors.

Fool contributor Dan Caplinger has both traditional and Roth IRAs and makes the most of both. He doesn't own shares of the companies mentioned in this article. Microsoft is a Motley Fool Inside Value recommendation. Google is a Motley Fool Rule Breakers pick. Dynamic Materials is a Motley Fool Hidden Gems recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Dynamic Materials. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't pull a fast one on you.


Read/Post Comments (3) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 12, 2010, at 9:41 AM, weg915 wrote:

    To make sure I understood:

    For a traditional IRA. If my husband is covered by a pension plan but I am not. I can still contribute to a traditional IRA and deduct it from our joint return, if our combined AGI is under 177,000. or is the limit 109,000?

  • Report this Comment On April 12, 2010, at 9:33 PM, xetn wrote:

    This article overlooks one big thing; the power of the government to change the tax laws. Although the income from a Roth is now tax free, that does not mean it will always be so. Just to illustrate the point, originally income from SS was not taxable. Originally, the tax rates were: 1 percent tax on net personal incomes above $3,000 with a 6 percent surtax on incomes of more than $500,000.

    I am not saying that this will happen, only that is possible. And, with the deficit growing at a very rapid pace and no end in sight, you can expect many changes. Just one already being talked about is a VAT. While many think this is ok, it will hurt everyone.

  • Report this Comment On April 12, 2010, at 9:40 PM, TMFGalagan wrote:

    @weg915 - Because you're not covered, you can deduct at least part of your contribution if AGI is under 177K.

    But since your spouse IS covered by a plan, your spouse's contribution is subject to the 109K limit. In other words, it may be possible for you to deduct your contribution but for your spouse NOT to be able to deduct your spouse's contribution.

    best,

    dan (TMF Galagan)

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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