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Across My Desk: Do's and Don'ts of IRAs



For those who have waited until now to do their taxes, make sure you don't forget about the benefits of IRAs, Roth IRAs or non-deductible IRAs.

What follows is a great piece written by Christine Benz, Morningstar's director of personal finance and editor of the Morningstar PracticalFinance newsletter: "Procrastinators, it's time to get on the stick.

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...

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 for the 2007 tax year... you have until April 15 to make a contribution, and, if you have cash on hand, you might as well fund your Roth for 2008 at the same time.

Do...

...Think of the IRA as a way to take control of your finances amid an unpredictable market.

Morningstar's IRA Calculator can help you identify the IRA type that a) you're eligible to contribute to and b) will allow you to maximize your return once taxes are factored into the equation. Input your data on the Eligibility tab to find out the answer to the first question, then turn to the Comparison tab to address the second.

...Evaluate whether a conversion from a traditional IRA to a Roth makes sense. To determine a conversion is worth your while, use the Conversion tab of the IRA Calculator to input some data about yourself and your IRA status.

...Consider tax-managed funds. 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.

...Bear in mind your overall asset-allocation plan. Before you pick securities for your IRA, use Morningstar's Instant 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. You can use Morningstar's Asset Allocator tool to see if your asset allocation is in the right ballpark.

...Be a contrarian. 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. Contrarian fund investors might also take a look at some recently reopened offerings whose managers say they're finding attractive opportunities.

Don't...

...Forget about your spouse. Married couples that include a working and non-working spouse can maximize their aftertax results by setting up IRAs for both individuals. A 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. Although you have to make your entire IRA contribution for the 2007 tax year by April 15, 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.

...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...."

Great advice. Hope you use it.


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