What is an IRA Account? With constant news regarding the social security system being in jeopardy, more people are looking for alternatives and supplements for retirement income. One easy way to save for retirement is through an IRA. An IRA is an individual retirement arrangement (although most think it stands for account). The purpose is for individuals to be able to contribute annually to retirement savings and provides tax advantages in doing so.

There are two types of IRA accounts, the traditional and the Roth IRA. Today we are taking a look at the traditional IRA account.  Why just the traditional?  Mostly because I’ve wrote A LOT on the Roth and variety is the spice of life. 

Savings to Your IRA Account

Almost anyone who has earned income can open and begin contributing to an IRA. Even minors are permitted to open IRA accounts as long as they have at some point earned income. The exception is that the IRA must be established before a person is 70 ½ years old.

How Much Can be Saved

The maximum amount that can be contributed to an IRA account each year is $5000. Once a person reaches age 50, they can begin contributing an additional $1000 annually for a total of $6000 in annual contributions.* There are penalties for early withdrawal, so once the money is invested in an IRA the investor should plan the money staying in the IRA account. Unlike a traditional savings account, withdrawals can not be made on a regular basis..

*contribution limits are subject to change

IRA Benefits

There are many benefits to opening an IRA account as early as possible:

• contributions are not taxed until the money is withdrawn
• the earlier one starts saving, the more money they will have saved or put aside for retirement
• the contribution reduces income for tax purposes
• there are exceptions for early withdrawal, so if you have an emergency you may be able to access the funds

How an IRA Works

Originally IRA’s were thought of as a way for those who do not have an employee sponsored 401(k) or 403(b) plan, to save for retirement. However, many people with a work related retirement plan also open an IRA for additional retirement savings.

Typically an IRA is set up through a bank or with the help of a financial adviser. It’s as easy as going online for an application and making an initial deposit. Once the account is open then the investor can decide how to fund the account. The most common and easy way is through CD’s. Stocks and bonds are also a great way to fund an IRA, however one must be familiar with the workings of the stock market or should consider hiring a broker.

Why Save?

With constant insecurity about the social security system and the ever lengthening life expectancy rate, people need more money for retirement then ever before. Establishing an IRA account as early as possible is a great way to help plan for the retirement life that you envision. If you haven’t started saving yet, there’s no better time to look into opening your own IRA account.

Most people have some sort of savings for retirement. While we know it’s beneficial to save, sometimes the additional money we lose from our wages to save for retirement can be a burden. The US Government implemented the savers credit back in 2002 as a way to encourage Americans to start saving more money for retirement. Since then the program has become permanent, and as of 2006 has remained available for those who qualify to claim on their income tax returns. Unlike tax deductions, tax credits can do more then just reduce the tax you owe, they can increase your refund. It is worth trying to see if you are eligible to claim this credit.

Who Qualifies

Not everyone is eligible to claim the savers credit. However, if you contribute to a retirement account like a Roth IRA and meet the other requirements you may be eligible to claim the savers credit. Students can not claim the credit, nor can someone who is claimed as a dependent on another persons tax return. You must also be 18 years old or older in order to apply for the credit.

Being eligible for the credit is dependent on your adjusted gross income (AIG). Your AGI must be below the set limits in order to apply. Here are the limits for each filing status:

• Single $27,750
• Head of Household $41,625
• Married filing jointly $55,500

What is the Credit

The savers credit is determined based on a percent of your total contribution to a retirement account. The maximum amount one is allowed to contribute to a Roth IRA is $5000 annually. The savers credit is figured on the first $2000 of that money or as much as you have contributed up to $2000. So for example, if you had contributed the full $5000 for the year, then you could claim credit on $2000. If you were eligible for a 50% credit, then you could subtract $1000 off your income on your tax return.

Because the savers credit is based on the person’s adjusted gross income in conjunction with their filing status, the amount of the credit will vary for all filers.

Exceptions

Contributions made to military retirement accounts do not qualify for the credit. Also, you can not claim the credit on rollover distributions, nor can you claim the credit on contributions made to repay a previous distribution.

How to Claim

In order to claim the savers credit for Roth IRA savings you must complete form 8880. You must file form 1040 or 1040A in order to use form 8880. It can not be use with form 1040ez. This form is filed with your regular tax return and supports your deduction. Even if you did not make any contributions in the previous year, you can still claim the credit up to the April 15th tax deadline.

photo credit: Stargazer95050

Don’t miss the 2011 IRA deadline. In the haste of getting all your tax documents in order to meet with your tax preparer, don’t forget about making your IRA contributions for the 2010 tax year. If you didn’t know, even though you haven’t opened an IRA account yet, you can still do so and still be eligible to make a contribution for 2010 – this applies both to traditional and Roth IRAs.

Now the one feature that you might notice for 2011, is that April 15, 2011, falls on a Friday which happens to be a holiday.   Taxpayers will have until Monday, April 18 to make their IRA contributions because Friday is Emancipation Day, a holiday observed in the District of Columbia.  By law, District of Columbia holidays impact tax deadlines in the same way that federal holidays do; therefore, all taxpayers will have three extra days to file this year and contribute to their IRA’s.

Please note: just because you have until the 18th of April to add to your IRA, does NOT mean you should wait until the 18th of April. Let me give you a quick story to attest to that.

Client Story and IRA Deadline

I had a client that is notorious for waiting until the absolute last minute in making their IRA contribution. Two years ago, it was the same routine to where they’re scrambling to get me a check on the last day possible. Luckily, they did make the deadline. However, there was a bit of a problem.

Apparently, the client had forgot to transfer funds into the checking account from which they wrote the check for the IRA contribution and the check bounced. Guess what happens when you write a check for your IRA and it bounces? You don’t get a second chance. Ultimately, since the check bounced, they were unable to make a contribution for that year. Had they came in much sooner, everything would have been fine.

Funny enough with that same individual, I went to them with

“Since you already have the money available now, why don’t we go ahead and make a contribution for this year so we don’t have to wait until next year and have a possible repeat occurrence?”

Although the client agreed with me, they still said they wanted to wait until later on. Guess what happened the following year? You guessed it. The same exact thing: last minute contribution. At least this time, the check cleared and they were able to make the IRA contributions for that year. Moral of the story is, don’t wait until the last minute. Although you have until the 18th of April, get it in there much, much sooner.

Update:

SEP IRA and Simple IRA Contribution Deadline

It should be noted that if you are a business owner and have either a SEP IRA or Simple IRA, your contribution deadlines differ.  Typically, you have until the tax filing deadline of the business to get the employer contributions invested into the plan.  With the Simple IRA, the employees portion that is deducted directly from their paychecks have to be in there within a reasonable time after the last pay period of year end (think January 21st).

photo credit: angelamaphone

Transcription follows below:

Hey everybody,  this is Jeff Rose from Goodfinancialcents.com. Today I am going to talk a little bit about a common question that I get quite frequently. This question is:

Is just having a 401k enough to have a successful retirement?

It is a very good question because a lot of people wonder about, am I saving enough? Am I putting enough away to make sure I get enough to retire when I want to retire and is the 401k only thing that we need to get us by? And I would say that generally speaking that answer is no. As far as my reasoning and logic behind that is this.

401k By Itself Is Not Enough

For one reason, most people that do have a 401 k, most of you are not maxing it out. This is what I’m gathered from my several client meetings of those that have the ability to put money in a 401k.

So are you putting in $16,500 per year in that 401k? If you are, you definitely have a fighting chance and if not then most likely the 401k is not going to be enough.

Note: See 2011 401k Contribution Limits

And if you have a good company that has a good match at top of that, obviously it will make it better. For those who are not putting the maximum amount in and not having good and favorable 401k match from your employer then you definitely have to consider other means and sources of savings.

You can obviously choose between traditional or Roth IRA. Both of those are excellent tools to complement the 401k and specially if you are doing the Roth IRA and you are doing the regular 401k that gives you pre tax money and after tax money. Both those together are a good compliment.

I know for me personally as a business owner  I have a SEP IRA which is kind of like my 401k.  Over and above that I have been able to do Roth IRA and a Roth IRA conversion.  That gives me some pre tax money and after tax money as well. Nothing like having options!

It’s Nice Having Options

Between the two, having a good 401k, having a Roth IRA traditional IRA, gives you another bucket to choose from. Me personally, I am not really counting on Social Security being there for me. And if it is there, it will most likely come at a later date, say 70 when I can get it, it will probably be a reduced amount. Do not plan on it being there, and utilizing 401k and Roth IRA as an alternate or replacement for that income. Between those two, another thing I would add is saving account and investment account, utilizing other investment savings tools to have that for you at retirement.

So to answer the question, if you have a 401k and is that enough? I will say no. Make sure that you are utilizing all the other tools. For me, I like having three buckets approach. If you got a 401k, Roth IRA it is another source of retirement income that could be a saving accounts or investment account. At least have three buckets, so you can always have choices when it comes to the retirement. One bucket dump’s over is depleted; you have got other buckets to choose from. So that was my advice to you. If you have any questions, feel free to email me, contact me on the blog.

You can also see my Soldier of Finance Video below that addresses having a “Multi-Bucket Approach For a Successful Retirement”.

You always hear that you need to “Save, Save, Save” for retirement, but is it really possible to save too much? When it comes to contributing to your IRA, it can.

Individual Retirement Accounts (IRAs) have annual contribution limitations that indicate how much you’re allowed to contribute. Anyone, regardless of income level can contribute to Traditional IRAs, but in addition to having a maximum contribution amount for a Roth IRA, you’ll also need to have annual income within limitations in order to contribute, at all.

It’s always best to prevent over contributions into IRAs, whether you have a Roth IRA or a Traditional IRA, so consult a tax professional if you have any questions about your allowed contribution amounts each year. If you do contribute more than you are supposed to, also consult a tax professional for advice on how to remove the overage to avoid penalties and tax implications.

Roth IRAs

For Roth IRAs, you can contribute $5,000 per year if you’re under the age of 50 and as much as $6,000 annually if you’re over the age of 50. The contribution limitation is adjusted based on your annual adjusted gross income, however. If you make between $105,000 and $120,000 a year as a single tax filer, you can make partial contributions based on the amount you earn. If you are married and make more than $166,000 but less than $176,000 you can also make partial contributions. If you make more than the stated annual income amounts, you’re not allowed to contribute to an IRA at all.

What if You Contribute Too Much in a Roth IRA?

If you contribute more than you are allowed into a Roth IRA, you can withdraw the amount over the limit by the date you file your income tax return. If you fail to withdraw the amount you’ve over contributed, you will have to pay 6% excise tax on the overage amount (and any earnings it has made).

Traditional IRA

Contributes to Traditional IRAs are tax deductible, and directly reduce the amount of taxable income you have in the year that you make your contributions.

Like a Roth IRA, you can contribute up to $5,000 per year, although if you earn less than $5,000 in a year you’re allowed to contibute 100% of your earned income (whichever is less). If you’re over the age of 50, you can make catch-up contributions of $1,000 for years 2009 and 2010.

What if You Contribute Too Much in a Traditional IRA?

If you contribute more than you are allowed into a Traditional IRA, you can withdraw the excess contribution before you file your income taxes without penalty. If you don’t realize the over contribution until after you’ve filed your taxes, however, you will withdraw the excess amount and be penalized 6% for each year the money remained in your account when it should not have been there. You’ll need to file IRS Form 5329 when you withdraw your funds and it can be treated as an “early withdrawal”. Under Traditional IRA early withdrawal rules, you could be taxed twice on the withdrawal.

How Does this Happen?

The most common time I see someone over contribute to an IRA (Roth or Tradtional) is when they have IRA’s at two different locations; for example, a bank at a brokerage firm. You have to understand that just because you have multiple IRA’s at different financial institutions doesn’t mean you can contribute $5,000 to each. That same rule applies to having both Traditional and Roth IRA’s.

Another time I see this occur is when someone has automatic contributions being directly deposited into their IRA. Either they forget the amount or just lose track of how much they’ve contributed (you should be always be able to check with your IRA custodian to see how much you’ve contributed). In the event that this occurs, you can always apply the excess contributions to a future tax year so as long as the amount does not exceed the contribution limit for next year, too. Keep in mind though that the 6% excess tax may still apply.

Keep Track of How Much You Put Into Your IRA

It goes without saying that the easiest way to prevent putting too much into your Roth and Traditional IRA’s is to keep track of how much you’ve added. As I’ve mentioned before, even if you lose track, your IRA custodian should have a record of how much you’ve contributed for the current tax year.

photo credit: Truthout.org

Saving for retirement is one goal commonly shared by most individuals. Unless you are independently wealthy or inherit enough money to feel confident you will never have to rely on savings (I did not either one of these), you most likely want to put money aside during your working years to ensure your comfort and security when you retire. This can be done in any number of ways, as there are dozens of different “types” of retirement savings plans from which to choose. Each plan has its own benefits and drawbacks making it important to find the one that best meets your current and long term financial needs. Members of the military and federal employees have additional savings tools at their disposal, making the decision where to save even more complicated. Here we look at two popular savings plans available to service members, their families and United States Federal Government employees.

Roth IRA-After Tax Today For Tax Free Later

A Roth IRA is available to any individual or married couple that fall under the income thresholds established by the IRS. To be eligible as a contributor to a Roth IRA, you must make contributions from taxable compensation such as that received from self-employment, wages, salaries, commissions and bonuses. Members of the military, government and civilians have access to a Roth IRA if they meet the required conditions.

Roth IRA contributions are made with after-tax dollars, meaning the account owner will never again pay income tax on contributions or earnings when taking them as qualified distributions. Qualified distributions include the withdrawal of contributions at any time and earnings after the account is open for five tax years and the owner is 59 1/2 years of age. This is very beneficial to individuals who may find themselves in a higher tax bracket when distributions are taken as income tax has already been paid and no further taxation will occur.

Thrift Savings Plans

Available to service members and federal employees, the Federal Thrift Savings Plan is another option to consider for retirement savings. This plan commonly recognized by its acronym TSP, is similar to the standard 401k with which most savers are familiar. Different from the Roth IRA in many ways, contributions to the TSP are made with pre-tax dollars which reduces the amount of taxable income in the year contributions are made. Of course, since taxes have not been paid on contributions, distributions from the TSP will be taxed. If you are in a higher income tax bracket when money is withdrawn, this can be a disadvantage.

Differences Between The Two

The differences between the two plans do not end at how they are taxes. Consider the following to help aid in your decision as to which plan is best for your financial needs.

Which One Did I Do?

Throughout my 9 year military career, I had access to both the Roth IRA and TSP. Since I was only in the National Guard, I mainly started with the Roth IRA, because I had more control over my investments. The TSP didn’t really become a viable option for me until I was deployed in 2005. Even though I could have socked away a ton of cash into it, I still opted to max out mine and my wife’s Roth IRA. Between that and really upping our emergency funds, we decided to pass on the TSP. Personally, I liked the control of the Roth IRA- I could buy what I wanted- and the potentially to have a tax-free nest egg waiting for me at retirement.

For active duty, the TSP might be more attractive since you can have it directly pulled out of your paycheck. The point of it all is that it’s never a bad thing to save. TSP or Roth- you just need to make sure you’re saving something for retirement. Both offer distinct advantages and in some cases disadvantages. Soldiers who have access to both a Roth IRA and TSP may benefit by first maxing out contributions to a Roth IRA and then putting additional savings in the TSP to gain the most benefits from both plans.

photo credit: hans s

Many people invest in the Roth IRA because it offers tax free growth, tax free withdrawals during retirement, and tax diversification while contributing to the retirement account. I know I’m all about “tax free”! Unfortunately though, there are times when you end up needing the money you’ve put in your Roth IRA before you retire. Of all the retirement account options you have, the Roth IRA is one of the most flexible in that it does allow you to make withdrawals of money you contributed at any time, without hefty early withdrawal penalty fees or tax penalties, under certain conditions.

If you make an ineligible withdrawal from your Roth IRA before you reach retirement age, you could end up paying a 10% early withdrawal penalty. The last thing you want do is give more to the IRS than they deserve.

Sorry, IRS. I don’t mind paying what is owed to you, but I’d rather not give you a dime more. We can still be friends, right?

Understanding Roth IRA Withdrawals

For the most part, you can withdraw the money you personal contributed to a Roth IRA at any time without taxes or penalties. You’ve already paid taxes on the money you contribute to a Roth IRA so you don’t need to pay tax on that money again when it’s taken out.

You cannot withdraw any of the earnings your contributions have made without penalty until you reach the age of 59 ½ and have had your Roth IRA for at least 5 years.

If you opened an IRA at the age of 58, normally you could begin receiving distributions from it at the age of 59 ½ but you’ll need to wait until you’re 63, five years after opening it, before you can pull any earnings from your Roth IRA penalty and tax free.

As with any rule, there are exceptions to withdrawals and distributions for Roth IRAs.

Qualified Roth IRA Distributions

A qualified distribution is a withdrawal from a Roth IRA that will be taken tax and penalty free. Qualified distributions are made after the age of 59 ½ and after the account has been opened for at least 5 years. Other qualified distributions may be taken if you become disabled, or for your first home. If you use money from your Roth IRA toward the cost of your first home, or the first home of your children or grandchildren. You can take up to $10,000 per Roth IRA account. Payments to a beneficiary after your death are considered qualified distributions, as well.

Non-Qualified Roth IRA Distributions

A non-qualified distribution is a withdrawal of money from your Roth IRA which are subject to taxes and/or early withdrawal penalties. Most non-qualified distributions will be taxed as income, and charged a 10% early withdrawal penalty (don’t be generous to the IRS), except for the following exceptions which are only subjected to income tax but not the 10% penalty:

Should You Take Money from Your Roth IRA?

photo credit: stephenvance

Just because you can make penalty and tax free withdrawals from your Roth IRA doesn’t mean it’s a good idea! It’s kind of like going to the Chinese Buffet. Just because you can get your fourth plate of General Tso’s chicken, doesn’t mean you should! (Although, I will admit that the picture above is pretty enticing) While it may not cost you as much to take money from a Roth IRA when compared to other retirement accounts, it still has a potential negative effect on your long term retirement savings goals.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions apply.

Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

Roth IRA Five Year Rule- Can You Dig It?

You might be asking yourself what the Jackson Five has to do with the Roth IRA five year rule for qualified withdrawals? I’m sad to say, “Absolutely nothing”. Other than then number “five”, of course. I just thought it was fitting with all the recent tributes to the King of Pop to have my own. Now that I have your attention…..

The basics of the Roth IRA include the phrase “Tax Free Money”.   That phrase makes the Roth IRA the most attractive retirement planning tool of our time.  When it comes to the intricacies of the Roth IRA, in regards to how it works, some confusion can set in.   One provision of the Roth IRA that can leave many scratching their heads is the Roth IRA Distributions Rules For Withdrawals: 5 year rule.

The Five Year Rule pertains to when you can take qualified distributions from your Roth IRA tax and penalty free.  Nobody wants to pay tax and penalties, right?  That’s why it’s important to know how the Roth IRA withdraw rule works.   Just to add more fun to the mix, you need to first know that there are two  sets of Five Year rules.  One pertains to Roth IRA contributions and the other pertains to Roth IRA conversions.  We’ll begin with Roth IRA contributions.

Withdrawal Rules on Roth IRA Contributions

In order for you to take money from the Roth IRA tax and penalty free, it has to be considered a “qualified distribution”.   We’ll get to what the rules on qualified distribution are in one moment.  First thing I need to remind you is that all contributions can be taken at any time, tax and penalty free.   That means what you put into the Roth IRA (contribution) can be taken out the following day without consequence (not factoring sales charges and market risk).  Let me illustrate:

Example 1

You open a Roth IRA at your bank and decide to put $5000 into a money market account inside the Roth.   A month goes by and something happens where you need to withdraw your money.   You can withdraw the original $5000 tax and penalty free.   What has to stay is the earnings or, in this case, the interest that you made off the $5000 (which should be minimal considering you didn’t have it that long).   Now keep in mind, the bank may charge you some cancellation fee of some kind, so read the fine print.  But as far as the IRS is concerned, you are in the clear.

Example 2

Just to illustrate another side of the first example, let’s say this time you decide to invest at a brokerage firm and choose an investment more tied to the stock market.   After a month goes by, your original $5000 investment now plummets to $3000. (I think a lot of people can relate to that).  All you are allowed to withdraw is the $3000.  That’s it!  Sometimes that gets overlooked.  Also, if you paid a sales charge or commission on that investment, that’s not being refunded to you either.

What is the Rule For Qualified Distributions on a Roth IRA?

What’s so important about a qualified distribution?  If it’s deemed qualified, you then avoid taxes and the 10% early withdraw penalty.  Taken directly from IRS pub 590 this defines what qualified distribution is:

A qualified distribution is any payment or distribution from your Roth IRA that meets the following rules:.

1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
2. The payment or distribution is:

• Made on or after the date you reach age 59½,
• Made because you are disabled,
• Made to a beneficiary or to your estate after your death, or
• One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).

Remember that you have until April 15 of the following calendar year to make a Roth IRA contribution for any tax year. But the five year window begins January 1st of the actual tax year.  Also, the five year window is based on when you made your first deposit.  Meaning that a new five year window does not begin with each additional deposit.  Is your head spinning?  Let’s look at another example:

Example 3

You open a Roth IRA but don’t actually make your first contribution until April 10th, 2006.  Your five year window would then begin on January 1st, 2005.   If you didn’t make another deposit until 2008, your five year window is still based on the January 1st, 2005 date.   Don’t forget that it’s Five Year rule plus one of the other factors (most likely 59 1/2) to get the money tax and penalty free.

(couldn’t resist having a picture of #5 Albert Pujols)

Roth IRA Conversions

The Five Year Rule works a bit differently when it pertains to Roth IRA Conversions.   The major difference is starting of a new five year window with each new conversion.  Once you reach the age of 59 1/2 this isn’t much of an issue, but you still need to aware of this. Especially, if you haven’t had a Roth IRA open for at least five years.  If so, the conversion amount will come out tax free, but the earnings are still subject to a five year holding period.  Let’s look at another example:

Example 4

If you started a Roth IRA at age 50 with a contribution and then decide to convert at ages of 58, 59, and 60 respectively,  you are immediately eligible to take all funds out tax and penalty free (even earnings) since you satisfied age and “any or “a” five year holding period in a Roth.

The above example is one what I wrestled with trying to find the answer and as it stands right now, that is the best interpretation of the rule that I’ve found.

Similar to Roth IRA contributions, the five year clock begins on January 1st of the year that you convert.  The key difference is that the you must convert in the calendar year and not the tax year: before December 31st.

Converting has been difficult to qualify for a conversion since your adjusted gross income has to be less than $100,000.  But as I’ve written about on more than one occasion,  Roth conversion rules change slightly and the income limit is removed in 2010.  Expect many to take advantage of this next year.

Keep it in Order: Rules For Taking out of Roth IRA

You have made it thus far- congratulations! We’re almost there.   The last step that we have to address is the ordering rules for taking out withdrawals from your Roth IRA.  This is important because of, once again, the taxes and penalties that might occur.  According to the IRS, the order of a distribution from a Roth IRA is:

1. Regular Contributions – by considering the first money withdrawn from the account “regular contributions,” and not earnings, the IRS allows account holders to remove a portion of their accounts before the five-year rule applies.
2. Conversions – this is on a first-in, first-out basis.  So the money placed into an account because of a conversion that occurred in 2008 would be removed before a conversion that occurred in 2009.
   1. Taxable – the taxable portion of the conversion is removed first.  This is the amount claimed as income because of the conversion.
   2. Non-Taxable – this is the portion of the conversion not included in gross income.
3. Earnings – finally, the last money to be removed from an account are the earnings on the assets placed in the account.

Logically, it makes sense.  The monies that you have paid taxes on will come out first tax and penalty free.   After the contributions are taken out, just work down the list to see what you can or cannot take.   Still confused?   This is where a CPA or a Certified Financial Planner can assist you computing the numbers for you.

Required Minimum Distributions and Roth IRA

One last note when doing conversions and you are over the age of 70 1/2.   Since you are the IRS magic age to begin required minimum distributions, those distributions can’t be converted to a Roth IRA. In the year you wish to convert, you must first withdraw your required distribution, and then you can convert any or all remaining funds to a Roth. This is only if you do a full conversion.  If you are looking to do a Roth IRA conversion at the beginning of the year, but postpone your RMD; then you’ll want to do a partial conversion and leave at least the amount of the RMD in the IRA.  Be sure to double check with your IRA custodian to see what their policy is on the matter of RMD’s and converting.  Keep in mind that in 2009 RMD’s are suspended, so that would not apply.  It will continue as scheduled in 2010.

If you’re one of the millions of American households who owns either a Traditional individual retirement account (IRA) or a Roth IRA, then the onset of tax season should serve as a reminder to review your retirement savings strategies and make any changes that will enhance your prospects for long-term financial security. It’s also a good time to start an IRA if you don’t already have one. The IRS allows you to contribute to an IRA up to April 15, 2009, for the 2008 tax year.

In either case, this checklist will provide you with information to help you make informed decisions and implement a long-term retirement income strategy.

Which Account: Roth IRA or Traditional IRA?

There are two types of IRAs available: the Traditional IRA and the Roth IRA. The primary difference between them is the tax treatment of contributions and distributions (withdrawals). Traditional IRAs may allow a tax deduction based on the amount of a contribution, depending on your income level. Any account earnings compound on a tax-deferred basis, and distributions are taxable at the time of withdrawal at then-current income tax rates. Roth IRAs do not allow a deduction for contributions, but account earnings and qualified withdrawals are tax free.¹

In choosing between a Traditional and a Roth IRA, you should weigh the immediate tax benefits of a tax deduction this year against the benefits of tax-deferred or tax-free distributions in retirement.

If you need the immediate deduction this year — and if you qualify for it — then you may wish to opt for a Traditional IRA. If you don’t qualify for the deduction, then it’s almost certainly a better idea to fund a Roth IRA.

Case in point: Your ability to deduct Traditional IRA contributions may be limited not only by income, but by your participation in an employer-sponsored retirement plan. (See callout box below.) If that’s the case, a Roth IRA is likely to be the best solution.

On the other hand, if you expect your tax bracket to drop significantly after retirement, you may be better off with a Traditional IRA if you qualify for the deduction. You could claim an immediate deduction now and pay taxes at the lower rate later. Nonetheless, if your anticipated holding period is long, a Roth IRA might still make more sense. That’s because a prolonged period of tax-free compounded earnings could more than make up for the lack of a deduction.

Should You Convert to Roth?

The IRS allows you to “convert” — or change the designation of — a Traditional IRA to a Roth IRA if you have an adjusted gross income of $100,000 or less. As part of the conversion, you must pay taxes on any investment growth in — and on the amount of any deductible contributions previously made to — the Traditional IRA. The withdrawal from your Traditional IRA will not affect your eligibility for a Roth IRA or trigger the 10% penalty normally imposed on early withdrawals.

The decision to convert or not ultimately depends on your timing and tax status. If you are near retirement and find yourself in the top income tax bracket this year, now may not be the time to convert. On the other hand, if your income is unusually low and you still have many years to retirement, you may want to convert.

Maximize Contributions

If possible, try to contribute the maximum amount allowed by the IRS: $5,000 per individual, plus an additional $1,000 annually for those aged 50 and older for 2008. Those limits are per individual, not per IRA.

Of course, not everyone can afford to contribute the maximum to an IRA, especially if they’re also contributing to an employer-sponsored retirement plan. If your workplace retirement plan offers an employer’s matching contribution, then that “free” money may be more valuable than the amount of your deduction. As a result, it might make sense to maximize plan contributions first, and then try to maximize IRA contributions.

Securities offered through LPL Financial, Member FINRA/SIPC

As you’ve read in other posts, I’ve talked about the importance of a 401(k) as well as a Roth IRA. Many clients have asked which one do I do over the other. A basic rule of thumb is if you do have a 401(k) that does have a match, take that first. The reason being is that that is free money and there’s no reason to pass up free money. Most 401(k)’s only match up to a certain percentage, so at least contribute as much as they match.

After the free money, Go for the tax-free money

If you have satisfied that and you still have more money to save, then let’s shift gears and let’s take a look at the Roth IRA. With the Roth IRA, you are allowed to put in up to $5,000 a year, $6,000 if you’re over the age of 50. Our goal then is to max out the Roth IRA after taking full advantage of the free match in the 401k retirement plan. Once the Roth is completely maxed out, then we come back to the 401(k) before we max that out, which is $15,500 per year up to $20,500 after over the age of 50.

Another case for Diversification

To further support this strategy is the simple principle of diversification.  Most 401k’s have limited investment options.  By opening a Roth IRA, you can then do investment options that are unrelated to your 401k, thus diversifying your portfolio even greater.  This is strategy that did in my Roth when I used to have a 401k with my previous employer.

Ahead Of The Game

If you’ve managed to max out both your 401(k) and your Roth IRA, well, you’re definitely ahead of the game, and after that we can discuss further options that you could possibly consider.

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Securities offered through LPL Financial, Member FINRA/SIPC