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Which IRA Is Right for You?

If you're trying to save for retirement, you probably know how an IRA can make a huge difference in your long-term success. But as with so many things that have to do with tax law, you have a number of different choices to consider -- and it can be tough to figure out exactly what kind of IRA is best for you.

Choosing the right IRA is important, so later in this article I'll give you some guidelines for deciding which type of account is most likely best for people in a number of common situations. First, though, let's make sure you're familiar with the different IRAs that are available.

An IRA by any other name
Originally, IRAs were designed to work alongside employer pension plans. The idea of the original IRA was simple: You would voluntarily set aside money from your current income with the intent of deferring your use of that money until after you retire. As a result, the IRS was willing to give you a tax break on that money now, in exchange for your agreement to include it -- along with any income it generated -- in your taxable income when you used the money in retirement.

But since then, the term "IRA" has been used in a number of contexts, not all of which have anything to do with retirement. So-called "Education IRAs" -- now known as education savings accounts -- operated much like retirement accounts, but with the goal of saving for college expenses, rather than retirement. "Simple IRAs" were simplified pension plans for small businesses to use in lieu of more complicated and expensive alternatives.

Another type of IRA, however, is of key importance. The Roth IRA is fundamentally different from traditional IRAs in that Roth IRAs offer tax-free income -- at the cost of giving up the tax deduction when you first contribute money into the account.

So how should you pick?
Deciding which IRA makes more sense for you is a function of several factors:

  • Which IRAs you're eligible for.
  • Your current tax rate, versus the tax rate you expect to pay after you retire.
  • What investments you expect to hold within the IRA.
  • Other retirement assets you own, whether in an employer-sponsored retirement plan account or a regular taxable account.

First of all, some taxpayers won't have a choice. Roth IRA contributions aren't available to taxpayers who earn more than a certain amount, so if you're above the threshold, a traditional IRA will be your only option. In some cases, you won't even be allowed to take a deduction for that traditional IRA.

But assuming you can choose either type of IRA, current and future tax rates play a key role. In general, if you expect your tax rate to rise in retirement, then a Roth IRA is preferable. But if your taxes will be lower in retirement, you'll get more value from a current deduction, even if you end up having to pay tax after you retire when you make withdrawals -- thus making a traditional IRA the smarter move.

In addition, the investments you'll choose make a difference. Traditional IRA withdrawals get taxed at ordinary rates, so it's often best to put investments that produce ordinary income in them. That includes mortgage REITs Annaly Capital (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) , whose huge dividends don't qualify for the preferential rates that some other dividend stocks enjoy. It also includes the fixed-income oriented ETFs SPDR Barclays Capital High Yield and iShares Barclays TIPS Bond (NYSE: TIP  ) , both of which produce dividends that actually represent interest income.

By contrast, if you expect to invest in high-growth plays, then the Roth IRA lets you escape tax entirely. It's even more valuable if you expect to reap profits in short time frames, because there, you wouldn't hold on to shares long enough to get favorable long-term gain rates, even in a taxable account. For instance, if you think that Aeterna Zentaris (Nasdaq: AEZS  ) and Keryx Biopharmaceuticals' (Nasdaq: KERX  ) perifosine will report favorable results from its phase 3 trials -- and that expectation isn't already baked into the stock price -- then placing a trade in a Roth IRA lets you grab the potential pop tax-free.

Either way is a smart move
In the end, don't let indecision about which IRA is best stop you from picking one. It's definitely better to open either type of IRA than to do nothing.

And as far as investments go, the right stocks fit well in just about any kind of account. Get some ideas from The Motley Fool's latest special report on retirement, where you'll find three promising stock picks for long-term investors. It's free, but don't wait; get your free report today while it's still available.

Fool contributor Dan Caplinger wants everyone to make the right choice. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is right for you.


Read/Post Comments (11) | Recommend This Article (9)

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 March 28, 2012, at 9:58 AM, wolfman225 wrote:

    Hey Dan.

    What's your opinion of the strategy of using both types of IRA? If you plan to put your money to work in several different types of investments, wouldn't it make sense to utilize both? You could use the tax-free income from the ROTH to offset some of the future taxable income from the withdrawals from the traditional IRA.

    I'm putting ~20% of my earnings into a 401k and the equivalent of another ~8% into dividend payers within a ROTH each year. I expect my tax rate at retirement to be appx the same as now, but if the government raises rates or completely revamps the tax code (hey, we can dream) I'm counting on the tax free income from the ROTH to soften the tax hit from the mandatory distributions from the IRA.

  • Report this Comment On March 28, 2012, at 10:18 AM, CluckChicken wrote:

    “Roth IRA contributions aren't available to taxpayers who earn more than a certain amount, so if you're above the threshold, a traditional IRA will be your only option.”

    What is that threshold? Let us follow the link:

    “The big problem, though, is that until recently, Roth IRAs weren't generally available to people with income above the contribution limits. That changed a bit in 2010, with a new law removing the income limits”

    Did I miss something?

  • Report this Comment On March 28, 2012, at 10:40 AM, BFatConservative wrote:

    @wolfman225

    I know several people who switch on a yearly basis depending on income situations. I.E. Coworker is having a baby, so the year that his wife is not working would be a Roth. The following year, wife is back to work, therefore a traditional.

    @CluckChicken

    There are still phase out limits for both Roth and Traditional. Roth is lower than Traditional.

    *I'm not a tax professional, should not considered investment advice.

  • Report this Comment On March 28, 2012, at 11:23 AM, oak00 wrote:

    "First of all, some taxpayers won't have a choice. Roth IRA contributions aren't available to taxpayers who earn more than a certain amount, so if you're above the threshold, a traditional IRA will be your only option. In some cases, you won't even be allowed to take a deduction for that traditional IRA."

    This is incorrect from a practical standpoint. Though it is true you cannot directly contribute to a Roth if you are above the income threshold, you can contribute to a Traditional IRA and then convert/transfer it into a Roth. So effectively there is always a backdoor to get money into a Roth regardless of your income levels.

    This is true since TIPRA 2005 eliminated the MAGI limit and filing status restriction on conversions starting in 2010.

  • Report this Comment On March 28, 2012, at 11:32 AM, rossirina wrote:

    I am not an advisor as well. I agree with Dan that regardless the type of IRA you should save for retirement in a tax efficient way.

    I believe that we should max contributions to our 401k plans before taking the IRA route (assuming you have such option). Two things that come to mind:

    1) It's simpler; you place it on a cruise control and it happens by itself.

    2) If you are lucky, your employer will match some of your contributions which is free cash no one gives you the IRA path.

    Go for it anyway.

  • Report this Comment On March 28, 2012, at 12:07 PM, BFatConservative wrote:

    @rossirina

    If you are like me and are very limited securities available in your 401k plan, or the options that exist have high expenses/fees, I would respectfully disagree with only focusing on a 401k.

    An IRA account with an E-trade / Ameritrade and have nearly limitless options at your disposal. Puts you more in the driver's seat.

  • Report this Comment On March 28, 2012, at 3:44 PM, TMFGalagan wrote:

    @wolfman225 -

    I like the idea of using both kinds of IRAs if you're eligible. That way, you hedge your bets as far as future tax rates are concerned.

    best,

    dan (TMF Galagan)

  • Report this Comment On March 28, 2012, at 3:45 PM, TMFGalagan wrote:

    @CluckChicken -

    Here are the updated phase-out amounts for 2011: http://www.irs.gov/newsroom/article/0,,id=229975,00.html

    best,

    dan (TMF Galagan)

  • Report this Comment On March 28, 2012, at 3:47 PM, TMFGalagan wrote:

    @oak00 -

    You're right that you can convert a newly created IRA to a Roth and get around the income limits that way. But if you already have existing IRAs and only want to convert part of them to Roths, it can get a little complicated - especially if some of the IRA contributions were nondeductible. It all depends on your current situation and what you've done in the past.

    best,

    dan (TMF Galagan)

  • Report this Comment On March 28, 2012, at 6:50 PM, jdwelch62 wrote:

    Can anyone tell me whether you can trade options within a Roth IRA at, say, TDAmeritrade or E*Trade?

    Thanks... :-)

  • Report this Comment On March 29, 2012, at 2:44 PM, oak00 wrote:

    @jdwelch62

    You can definitely do options trading in a TDAmeritrade Roth IRA (I'm doing that exact thing), but the account is not eligible to be a margin account. So that means you can write covered calls and cash-secured puts - and other option combinations that doesn't result in a net margin requirement. I imagine other brokerages are the same - but I don't know for sure.

    A Roth is a good place to do these kinds of trades, IMO. e.g. In my regular account I'm a bit less inclined to write covered calls on anything I've owned for less than a year, because I get hit with the extra capital gains if the stock gets called away (I still write them when appropriate, but I need more "room" for the math to make sense due to that potential extra hit). In the Roth, that particular drawback of conservative covered calls is removed (though the other drawbacks remain).

    I wish I had started my IRA at a younger age, as it is very small in size compared to my regular account - but is moving up pretty fast due to flexibilities like this.

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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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