The Tax Benefits of an IRA

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With forms showing up in mailboxes, the tax season is getting underway, and there’s not much one can do to affect the 2009 tax bill other than to avoid mistakes on the return. But taxpayers do have until April 15 to make one potentially valuable decision — whether it makes sense to put money into an IRA.

If you are eligible for a Roth IRA, or can get a tax deduction on a traditional IRA, the answer is probably “yes.” You can put in $5,000 a year ($6,000 if you’re over 50). But what if you don’t qualify for one of those IRAs? You still can contribute to a traditional IRA, but with no deduction on contributions. Are these worth the bother?

For many investors, they are not. But some can squeeze some benefit from them.

To back up for a second, Roths offer no deduction on contributions, but all withdrawals are tax-free, including investment gains. To open a Roth, your income must be less than $120,000 for individuals and $176,000 for couples filing joint returns.

With traditional IRAs, investment gains and deductible contributions are taxed as income upon withdrawal. Anyone can open a traditional IRA, but you must meet certain requirements to deduct contributions. Look at this T. Rowe Price (Stock Quote: TROW) explanation.

In a traditional IRA with no deduction on contributions, the investor gets the benefit of tax-deferred gains. But because withdrawals from all traditional IRAs are taxed as income at rates as high as 35%, it may be better to use an ordinary taxable account for certain types of investments. Long-term capital gains are taxed at a maximum of 15% in a taxable account, while an identical holding is taxed as high as 35% in the traditional IRA.

Also, long-term gains in a taxable account are not taxed until the assets are sold. So the buy-and-hold investor can use these accounts to defer taxes just as effectively as with a traditional IRA, and then pay taxes at a lower rate.

A taxable account is therefore better than a non-deductible IRA if you plan to invest in stocks or stock funds whose returns come primarily from long-term capital gains. That would include many index-style investments, either mutual funds or exchange-traded funds.

The non-deductible IRA would be better for investments that would produce lots of annual taxes in a taxable account, since the taxes would be deferred in the IRA. This includes many actively managed mutual funds that have large asset turnover, which tends to produce big year-end distributions.

It also includes bonds and bond funds with lots of interest earnings. Interest is taxed as income in both the taxable account and the IRA, but the tax can be deferred until withdrawal in the IRA.

Finally, the traditional IRA is a good choice for the investor who would prefer a Roth but doesn't qualify. Under rules that took effect Jan. 1, anyone can convert a traditional IRA, either deductible or non-deductible, into a Roth. Previously, individuals and couples earning more than $100,000 couldn't convert. Now you can put money into a traditional IRA and then quickly convert it to a Roth.

Although you have to pay tax when you convert, withdrawals from the Roth will be tax-free. Conversions are good for investors who think their tax bracket will be higher when money is withdrawn, since they can pay tax now to avoid a bigger tax later. Use the Roth IRA Conversion Calculator to see if this makes sense for you.

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