IRA Dos and Don'ts

With the market revisiting the lows it touched last fall, it's hard to get too excited about investing, period, even in a vehicle that promises a measure of tax savings such as an IRA.

Moreover, the IRA rules are confusing and off-putting under the best of circumstances. 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 choice: what type of investment to put into the IRA wrapper. 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 2008 tax year, don't let choice overload bury you. You have until April 15 to make a contribution, and, if you have cash on hand, you might as well fund your Roth for 2009 at the same time.

Here are some dos and don'ts to keep in mind:

Do

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 that you're taking advantage of every tax-sheltered opportunity available to you, such as contributing to an IRA.

Use Morningstar's IRA Calculator. This tool 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. As I noted in a recent article, I think the time is ripe for IRA conversions. Many IRA balances are way underwater, meaning that investors don't have any investment earnings, and those who have contributed to a Roth or nondeductible traditional IRA and have investment losses won't pay any taxes at all upon conversion. Also, starting in 2010, 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. To determine whether such a conversion is worth your while, use the Conversion tab of the IRA Calculator to input some data about yourself and your IRA status. (You'll have to take a flier on estimating future tax rates; I think it pays to be conservative and assume that tax rates will stay steady or go up in the years ahead.)

Consider tax-managed funds. If the IRA Calculator tells you that 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'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. Premium Members at Morningstar.com can use Morningstar's Asset Allocator tool to see if their asset allocations are in the right ballpark. (For a free 14-day Premium Trial Membership, click here.) Alternatively, you can compare your portfolio with a target-date fund designed for someone in your same age range. (Our analysts like Vanguard's Target series and T. Rowe Price's Retirement funds the best.) If you find that 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 more than 1,000 companies that they believe are trading cheaply right now. Contrarian fund investors might also take a look at some 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.

Don't

Forget about your spouse. Married couples that include a working and nonworking spouse can maximize their aftertax 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 that you need a lot of cash on hand to invest in an IRA. Although you have to make your entire IRA contribution for the 2008 tax year by April 15, you can spread your 2009 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. To the extent that you own 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 ultracheap 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. This article walks you through the rollover process, and fund companies and supermarkets should also be happy to help. (After all, they'll be earning fees on your assets!)

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 your contributions to a Roth IRA at any time and for any reason, and you can also withdraw money from an IRA, free of penalty, in certain situations, such as to buy a first home. 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 $16,500 to a 401(k) in 2009 ($22,000 if you're over 50). 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 mother lode 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. (The Roth 401(k) is another way to hedge against the possibility of higher taxes in the future.)

Christine Benz has a position in the following securities mentioned above: LLPFX