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.
