The Ins and Outs of IRA Plans …

After last week’s column on Solo 401(k) plans, I got some great questions on other retirement account options, especially IRAs.

I can’t think of a better time to address those other choices … especially since tax day — which represents your deadline for funding a 2010 IRA — is rapidly approaching!

So let’s get right into it …

The Ins and Outs of
Individual Retirement Accounts

Like 401(k)s, these plans were created by amendments to the Internal Revenue Code. And they serve much the same purpose — allowing individuals to sock away money for retirement and reap tax benefits in the process. But they come in many more flavors.

Let’s start with the biggest categories …

With traditional IRAs:

You contribute pre-tax money and thus save on your current taxes by lowering your taxable income …

Your contributions and earnings will be subject to taxation upon withdrawal …

And you must stop contributing and begin withdrawing money at age 70½.

Meanwhile, with Roth IRAs:

You contribute after-tax money and thus gain no upfront tax-savings benefit. But …

Your contributions — and earnings — will never be taxed again, so long as you meet the basic guidelines (eligible age of 59½ and held for at least five years)!

Plus, you can continue socking away money as long as you have earned income, no matter what your age. And you never have to make minimum withdrawals, even if you live to be 110.

Now, BOTH of these account types:

1. Give you a huge range of investment choices, pretty much everything offered by your broker …
2. Can be funded until tax day of the following year. In other words, you can put money in for 2010 as late as this coming April 18!
3. Allow catch-up provisions for contributors over the age of 50. In 2010 the regular limit for either IRA is $5,000 and $6,000 for age 50+.

However, it’s important to note that you can only contribute to a Roth IRA if your Modified Adjusted Gross Income (MAGI) falls within certain levels.

So what are the two major Roth IRA MAGI category limits for the 2010 tax year, then?

If you file as a single taxpayer, you have to make $104,999 or less to make the maximum contribution. You can make a partial contribution if your MAGI is between $105,000 and $119,999. And you’re barred from making any contribution to a Roth IRA if you earn more than $120,000.

Meanwhile, if you’re married and file jointly, your MAGI has to come in below $166,999 for the maximum contribution. You can make a partial contribution with MAGI between $166,001 and $176,999 but nothing above that range.

It’s worth sorting out the retirement accounts that make the most sense for YOU!

Regular IRAs, on the other hand, have no income restriction for contributions, though the tax deductibility can be affected by your MAGI.

There are no age restrictions for Roth IRAs — as long as you have earned income you can start socking away money. Your ability to contribute is also unaffected by any retirement plan you might have through your employer.

Just remember that you cannot max out both a regular and Roth IRA in the same tax year. Your total contributions to all IRA accounts (not counting rollovers and such) must fall within the aforementioned ranges.

Other Important IRA Flavors
You Should Know About …

Of course, there are other types of IRAs beyond the most common traditional and Roth versions.

Rollover IRAs act just like traditional IRAs but they’re funded by converting other retirement plans such as 401(k) plans.

In other words, if you leave your current employer (for any reason) you don’t have to keep your money parked in their retirement plan. Instead, you can convert it into an IRA account instead. Some of the advantages of doing so include easier account management and greater investment choices.

For the self-employed, there are also SEP IRAs and Simple IRAs. Both types allow small businesses or self-employed individuals to sock away money in lieu of establishing pension plans.

How do these differ from the Solo 401(k) plans I discussed last week?

In the case of the SEP IRA, there are more similarities than differences … especially since both allow contributions as high as $49,000 a year.

But because of the way contributions are figured, the Solo 401(k) tends to provide a bigger sweet spot for middle-income folks. And it also allows the possibility of taking a loan out while the SEP IRA offers no such choice.

Last but not least, there are also self-directed IRAs, which allow you to invest in a broad range of items, including real property such as land and houses.

Plenty of exclusions apply — for example, you can’t buy a house in your IRA and rent it to yourself — but sophisticated investors wishing to invest in “non-traditional” assets should take a closer look at these plans.

Okay, So How Can You
Put All of This Together?

I realize this can seem overwhelming. But let me provide some basic guidelines to consider:

1. If you have a 401(k) plan through your employer, I still suggest contributing to that first … at least up to the point where you get the maximum match.
2. If you’re self-employed, I favor the Solo 401(k) in most cases.
3. If you have additional money to sock away, I would then opt for an IRA … preferably the Roth if you qualify.

By following this simple arrangement, you will be taking advantage of as much “free money” as possible. You will benefit from a solid upfront tax advantage. And by contributing additional funds to the Roth IRA you are basically hedging your tax bets going forward.

Besides, given the ability to roll over 401(k)s into IRAs … and the newly relaxed rules for converting traditional IRAs into Roth IRAs … this basic plan also gives you the maximum flexibility going forward.

Best wishes,

Nilus

P.S. And if you’re looking for ideas on what investments to put into your IRA accounts, just click here to learn precisely what I’m doing for my own father’s IRA at Vanguard.