Investing tip of the month from Morningstar Investment Research Center, by Christine Benz, Director of Personal Finance
It's easy to see why investors often put off setting up an IRA. Nothing is altogether simple when the IRS is involved, so there are three key IRA types--the Roth, the deductible IRA, and the nondeductible IRA--all of which have varying pros, cons, and eligibility requirements. That can make it difficult to determine what type of IRA is right for you given your income, your time horizon, and your goals.
And even if you've identified the right IRA type, you'll have to navigate an even bigger, badder maze of choices. Having too many options can lead to what behaviorists call "choice overload." That means that when individuals are confronted with too many options, they often choose to do nothing at all.
If you've been putting off funding your IRA, don't let choice overload bury you.
Here are some dos and don'ts to keep in mind:
Think of the IRA as a way to take control of your finances amid an unpredictable market. You know that old saying about having the wisdom to know what you can and can't control? Well, you can't control the market's ups and downs, but you certainly can make sure that your investments are as good as they can be, your investment costs are low, and you're taking advantage of every tax-sheltered opportunity available to you, such as contributing to an IRA.
Evaluate whether a conversion from a traditional IRA to a Roth makes sense. In 2010, this question will be relevant for a lot more savers because investors of any income level will be able to make the conversion and will also be able to spread the tax hit over 2011 and 2012.
Consider tax-managed funds. If you're eligible to contribute only to a traditional nondeductible IRA, yet another option to consider is a tax-managed fund. Planners often steer those who earn too much to contribute to a Roth to a nondeductible IRA, but you'll have to start taking withdrawals at age 70 1/2 from the IRA. A tax-managed fund, by contrast, offers no such strictures but offers the same tax-deferred compounding. I'm a big fan of Vanguard's suite of tax-managed funds.
Bear in mind your overall asset-allocation plan. Before you pick securities for your IRA, use Morningstar Investment Research Center's Portfolio X-Ray tool to size up your whole portfolio's stock/bond/cash/international mix and take note of any big sector or style biases; also note whether you have any gaping holes in your portfolio. If you find you need to add to your holdings in a certain asset class or investment style, your IRA is a logical place to start.
Pay attention to asset location. By that I mean you should try to optimize what types of securities you hold in your taxable accounts and what you hold in your tax-sheltered ones. There's no need to go out of your way to find investments that incur a lot of taxes, such as fast-turnover stock funds or high-income bond funds. But to the extent that you hold such vehicles, you may want to do so within the confines of your IRA.
Be a contrarian. Although you may be a long ways away from retirement, it's always worth considering whether it's a good or bad time to buy a given security. (There's no faster way to decimate your investment results than to use the one-year performance tables as a shopping list!) Morningstar's equity analysts have identified a number of good-quality companies that they believe are trading cheaply right now. Just click on Stock Recommendations on the main page of Morningstar Investment Research Center. Contrarian fund investors might also take a look at some recently reopened offerings whose managers say they're finding attractive opportunities; two of my favorites include Longleaf Partners and Dodge & Cox Stock. These funds would make fantastic IRA options.
Forget about your spouse. Married couples that include a working and non-working spouse can maximize their after tax results by setting up IRAs for both individuals. A so-called spousal IRA is an option as long as you file a joint return and the working spouse has earned enough qualifying income to fund both his or her own IRA and that of the spouse.
Assume you need a lot of cash on hand to invest in an IRA. You can spread your 2008 contributions throughout the tax year. Such a strategy, called dollar-cost averaging, helps ensure that you're not putting money to work when the market's peaking. It also makes an IRA a more affordable option for those who don't have the full contribution amount on hand. Ask your brokerage, supermarket, or fund company to help you set up regular monthly contributions to an IRA.
Shelter investments with tax benefits, such as variable annuities or municipal bonds, inside an IRA. IRAs already offer tax-deferred (or in the case of a Roth, tax-free) compounding, so there's no need to stash tax-advantaged instruments like municipal bonds or variable annuities within them. Save those tax-favored options for your taxable accounts, and consider them only after you've maxed out your tax-sheltered options.
Let assets languish in a lackluster 401(k). Are your retirement assets sitting in your 401(k) account at your former employer? That's fine if your ex-employer fielded an ultra-cheap plan with great investment options, but many 401(k) plans aren't particularly distinguished and are larded with extra fees. Think about rolling the plan assets into an IRA, which opens up a huge array of investment choices.
Put off investing in an IRA because you may need the money for a shorter-term goal. Newer investors might steer clear of an IRA because they assume they'll be socking away the money forever and ever. Not necessarily. In fact, you can withdraw money from an IRA, free of penalty, to pay for qualified higher-education expenses or to fund a first home, among other financial needs. (You'll have to pay tax on a qualified withdrawal from a traditional IRA, however.) IRS Publication 590 provides complete details on when it's possible to tap your IRA penalty-free.
Assume that you don't need to contribute to an IRA if you already contribute to a 401(k). If you're maxing out your 401(k), pat yourself on the back; after all, you can contribute $15,500 to a 401(k) in 2008. But even dedicated 401(k) savers might want to consider an IRA as well. That's because IRAs can help you diversify the tax treatment of your retirement assets. For example, if you're contributing the max to your 401(k), you'll owe taxes on a motherlode of assets when you retire and begin tapping the assets. Withdrawals on Roth IRA assets, meanwhile, will be tax-free. By hedging your bets among the two vehicles, you have less riding on a wager about whether tax rates will be higher or lower in the future; you also maximize your tax-deferred savings.
Christine Benz is Morningstar's director of personal finance and the editor of the Morningstar PracticalFinance Newsletter.
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