Let's face it: Most people open IRAs not out of any great desire to save for retirement but rather because they offer a quick way to get a lucrative tax break. What you may well find, though, is that choosing a retirement account simply to get an IRA tax deduction could end up costing you a whole lot more in taxes down the road.
Fortunately, there's an alternative that lets you turn the tables on the IRS, paying an up-front cost now in order to save a whole lot more on your tax returns in the future. Before getting to that, let's take a look at what's involved in deductible IRAs and why so many people just take the money and run.
IRAs, deductions, and you
Traditional IRAs allow you to contribute up to $5,000 for the 2012 tax year, plus an additional $1,000 if you're 50 years old or older. If you meet certain requirements, you'll be able to deduct that contribution on your tax return.
The requirements differ depending on your income and filing status, as well as whether you (or your spouse, if you're married) are eligible to participate in a 401(k) or other employer-sponsored retirement plan at work.
Let's start with the simplest cases. If you're single and don't have a retirement plan at work, or if you file jointly and neither you nor your spouse has an employer plan available, then you can deduct your contribution regardless of how much income you make.
For those covered by employer-sponsored retirement plans, the math gets trickier. Single filers making more than $68,000 in adjusted gross income aren't allowed to take an IRA deduction. For joint filers, the limit is $112,000. In each case, you'll only be eligible for a partial deduction if you make slightly less than the limit -- within $10,000 for singles or $20,000 for joint filers.
Finally, if you're not covered at work but your spouse is, then a higher limit applies. If your total adjusted gross income is $183,000 or more, you won't be able to deduct your IRA contribution. Under $173,000, you'll get a full deduction.
Why you might not want the deduction
Even if you're entitled to an IRA deduction, though, you may prefer a different choice: namely, a Roth IRA. That's because in exchange for giving up your deduction, you instead get the benefit of tax-free withdrawals after you retire.
To understand why a Roth IRA may be more valuable, consider the way traditional IRAs work. You get an upfront deduction, but you have to pay tax at regular rates when you pull your money out. Not only will your original contribution get taxed but also every bit of income and price appreciation your investments generated.
The more successful your investments, the bigger a deal that is. For Monster Beverage (NASDAQ:MNST), American Tower (NYSE:AMT), and Titanium Metals (NYSE:TIE.DL) -- all of which have posted gains of at least 5,000% over the past 10 years -- the difference is staggering. For Monster, at top tax rates, you would pay nearly 60 times your initial investment in taxes alone. With American Tower and Titanium Metals, the corresponding figures are about 20 times and 16 times your initial purchase.
Of course, much of those returns come from having perfect timing in buying near the bottom of the bear market in 2002. Yet while these results are extraordinary, you'll get similar if somewhat smaller benefits with a wide range of investments. Expand your time frame to 20 years -- just half the length of a typical career -- and more mainstream stocks IBM (NYSE:IBM) and Procter & Gamble (NYSE:PG) reveal the value of the Roth IRA.
With their own income limits, Roth IRAs aren't available to many high-income taxpayers. But interestingly, the less you make, the better off you are with a Roth, because the deduction you give up at the beginning is worth correspondingly less for low-bracket taxpayers.
So instead of just opening a regular IRA and taking the immediate tax break, think about whether a Roth IRA would be a better long-term move. In the end, a Roth could save you a whole lot more in taxes.