Saturday, April 2, 2011

2010 IRA Contribution: It’s Not Too Late

You have until April 18 to make your IRA contribution for 2010. If you don’t have an IRA yet, now would be a great time to start one. If you can afford at least $1,000, you can open an IRA account at Vanguard and use their STAR fund, which invests in both stocks and bonds. With $3,000, you can choose from most other Vanguard funds. It only takes about 10 minutes to open an IRA account online at Vanguard, and you can have the money electronically transferred from your checking or savings account into your new IRA account. If you can’t afford $1,000, then you can open an IRA at Schwab with as little as $100, and you should be able to do so in a few minutes online; Schwab offers a few good low-cost index mutual funds and ETFs. Don’t hesitate to pick up the phone and call the Vanguard or Schwab representative if you need help.

If you don’t want to make the decision right now about how to invest in your IRA, then make your contribution to a cash account or money market fund (at Vanguard use the Prime Money Market fund, minimum investment $3,000). You won’t make much interest, but you’ll have some time to figure out how you want to allocate your investment between stocks and bonds (using one or more low-cost index mutual funds)

As discussed in previous posts, either a traditional IRA or Roth IRA may better for you.

If you are eligible for the full deduction, a traditional IRA contribution could lower your 2010 tax bill significantly (increase your refund, or decrease the additional amount you need to pay). For example, if you are in the 25% federal tax bracket and 8% state tax bracket, your tax savings could be as much as 33% of your traditional IRA contribution. If you are under age 50 you can contribute up to $5,000, so this would be a tax savings of $1,650 (if you are eligible for the full deduction). If you are age 50 or over, you can contribute up to $6,000, and save almost $2,000 in taxes (if eligible for the full deduction). To determine if you are eligible to take the full deduction for a traditional IRA contribution, see How Much Can I Deduct? in IRS Publication 590.

Contributions to a Roth IRA don’t lower your current tax bill, but earnings in a Roth IRA are not taxed, so your withdrawals in retirement will be tax free. If you are covered by a retirement plan at work (e.g., a 401k or pension) and your income exceeds certain limits, you can’t take a deduction for a traditional IRA contribution, so a Roth IRA is the obvious choice. However, if you make really big bucks, you may not be eligible to contribute to a Roth IRA. See Can You Contribute to a Roth IRA? in IRS Publication 590.

It’s possible that you could end up not paying taxes on withdrawals from a traditional IRA, in which case you would get the benefit of the current tax deduction plus tax-free withdrawals in retirement (like a Roth IRA). How can this be? Your income in retirement is likely to be much lower than when working, since you won’t have any earned income. But you still get to take deductions and exemptions, so a certain amount of income (interest, dividends, traditional IRA withdrawals, etc.) is not taxed. Social Security income is not taxed unless your other income exceeds a certain limit. So, if you don’t expect to amass enough wealth to generate significant investment income in retirement, and don’t have a generous pension, a traditional IRA is likely to be the better choice for you. Generally, if you expect to be in a significantly lower tax bracket in retirement than while working and contributing to your IRA, a traditional IRA is the better choice, assuming you are eligible for the full deduction.

Deciding between a traditional IRA and a Roth IRA isn’t always easy, but don’t let that stop you from making your 2010 contribution before it’s too late. It’s better to contribute to either type of IRA rather than none at all. Be sure to review IRS Publication 590 or talk to your tax advisor to ensure that you are eligible to take the deduction for a traditional IRA contribution, or to contribute to a Roth IRA. The relevant sections in Pub 590 are clearly labeled in the Table of Contents; e.g., Who Can Open a Traditional IRA?, How Much Can Be Contributed?, How Much Can You Deduct?, Can You Contribute to a Roth IRA?, etc.

Want to do it but still confused? Post a comment or drop me an email at, and I’d be glad to provide additional input.

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